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to accompany

Ehrenberg & Smith

Modern Labor Economics: Theory & Public Policy Eighth Edition

Robert S. Smith Cornell University Robert M. Whaples Wake Forest University Lawrence Wohl Gustavus Adolphus University

Copyright 2003 Addison-Wesley, Inc. All rights reserved. Printed in the United States of America. No part of this book may be used or reproduced in any manner whatsoever without written permission from the publisher, except testing materials and transparency masters may be copied for classroom use. For information, address Addison-Wesley Higher Education, Pearson PLC 75 Arlington Street, Suite 300, Boston, Massachusetts 02116.

This Instructor's Manual is intended to summarize the content of the eighth edition of Modern Labor Economics: Theory and Public Policy in a way that explains our pedagogical strategy. Summarized briefly, we believe that labor economics can be best learned if students are (1) able to see the "big picture" early on, so that new concepts can be placed in perspective; (2) moved carefully from concepts they already know to new ones; (3) motivated by seeing the policy implications or inherently interesting insights generated by the concepts being taught. To this last end, we discuss policy issues in every chapter and, in addition, employ "boxed examples" to demonstrate in historical, cross-cultural, or applied managerial settings the power of the concepts introduced. The text is designed to be accessible to students with limited backgrounds in economics. We do employ graphic analyses and equations as learning aids in various chapters; however, we are careful to precede their use with verbal explanations of the analyses and to introduce these aids in a step-by-step fashion. To help students in the application of concepts to various issues, we have printed answers to the odd-numbered review questions for each chapter at the back of the book. We have also endeavored to put together a text that, while accessible to all, is a comprehensive and up-to-date survey of modern labor economics. There are 9 chapter appendices designed to be used with more advanced students in generating additional insights. In the first part of this Instructor's Manual, we present a brief overview and the general plan of Modern Labor Economics. We then present a chapter-by-chapter review of the concepts presented in the text. In the discussion of each chapter we list the major concepts or understandings covered, and in some cases suggest topics or sections that could be eliminated if time must be conserved. We also present our answers to the even-numbered review questions at the end of each chapter. An important part of this Instructor's Manual are the suggested essay questions related to each chapter. We present a few suggested essay questions for each chapter.

Table of Contents
Click on the chapter title to jump directly to that page.

Overview of the Text Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Introduction Overview of the Labor Market The Demand for Labor Labor Demand Elasticities Quasi-Fixed Labor Costs and Their Effects on Demand Supply of Labor to the Economy: The Decision to Work Labor Supply: Household Production, the Family, and the Life Cycle Compensating Wage Differentials and Labor Markets Investments in Human Capital: Education and Training Worker Mobility: Migration, Immigration, and Turnover Pay and Productivity Gender, Race, and Ethnicity in the Labor Market Unions and the Labor Market Inequality in Earnings Unemployment

1 4 8 14 20 26 32 37 45 51 57 62 68 77 84 88

4. They are written to be accessible to students without backgrounds in intermediate theory. Chapter 5 analyzes the quasi-fixed nature of many labor costs and the ways these costs affect the demand for labor. Therefore.OVERVIEW OF THE TEXT INTRODUCTION/REVIEW: Chapters 1 and 2 Chapter 1 . In Chapter 4 we move to a discussion of the elasticity of demand. therefore. be used as building blocks when a professor must "begin at the beginning. The purpose of this appendix is to present enough of the basic econometric concepts and issues to permit students to read papers employing ordinary least squares regression techniques. We strongly recommend assigning Appendix 1A in courses requiring students to read empirical papers in the field." If the course is being taught to economics majors with intermediate microeconomics as a prerequisite. The concepts are used to analyze how technological change and foreign trade affect labor demand.Labor Demand Elasticities Appendix 4A .Graphic Derivation of a Firm's Labor Demand Curve Chapter 4 .Quasi-Fixed Labor Costs and Their Effects on Demand The demand for labor is discussed first primarily because we believe that the supply of labor is a more complex topic in many ways. we note that Chapters 6 and 7. 1 .Statistical Testing of Labor Market Hypotheses Chapter 2 . we first introduce students to the employer side of the market.Overview of the Labor Market Chapters 1 and 2 introduce basic concepts of labor economics. are selfcontained. In Chapter 3 the principal question analyzed is why demand curves slope downward. and 5. Finally. and can. We also recommend (in footnote 3 of the appendix) an introductory econometrics text that could be assigned by instructors who wish to go beyond our introductory treatment. and analyze the determinants of the precise relationship between wages and employment.International Trade and the Demand for Labor: Can HighWage Countries Compete? Chapter 5 . these chapters may be skipped or skimmed quickly as a review. however. which deals with that decision. THE DEMAND FOR LABOR: Chapters 3-5 Chapter 3 .The Demand for Labor Appendix 3A . An appendix to Chapter 1 introduces the student to econometrics. Before analyzing the labor/leisure choice and household production. nothing would be lost if Chapters 6 and 7 were taught ahead of Chapters 3.Introduction Appendix 1A . For instructors who desire to cover topics concerned with the decision to work first.

Chapters 8 through 10 analyze these choices. Chapters 9 and 10 analyze issues affecting worker investments in skill acquisition (Chapter 9) and job change (Chapter 10). ANALYSES OF SPECIAL TOPICS IN LABOR ECONOMICS: Chapters 11-15 Chapter 11 . Chapter 7 could be skipped.A Hedonic Model of Earnings and Educational Level Chapter 10 .Pay and Productivity Chapter 12 .A "Cobweb” Model of Labor Market Adjustment Appendix 9B .SUPPLY OF LABOR TO THE ECONOMY: Chapters 6 and 7 Chapter 6 . however.Gender.Estimating "Comparable Worth" Earnings Gaps: An Application of Regression Analysis Chapter 13 . Chapter 8 presents an analysis of job choice within the context of jobs that differ along nonpecuniary dimensions. In one-quarter courses or courses in which time is scarce. and Turnover Once they have decided to seek employment.Compensating Wage Differentials and Labor Markets Appendix 8A . More particularly. FACTORS AFFECTING THE CHOICE OF EMPLOYMENT: Chapters 8-10 Chapter 8 . and the Life Cycle Chapters 6 and 7 analyze the decision of an individual to work for pay. All three chapters contain appendices of interest to instructors who wish to teach more advanced material. The traditional analysis of the labor/leisure choice is given in Chapter 6. Race. As noted above. and both employ the concepts of human capital theory. with Chapters 8 and 9 focusing on industry/occupational choice and Chapter 10 on the choice of a specific employer and the location of employment. while in Chapter 7 the decision to work for pay is placed in the context of household production.Worker Mobility: Migration. doing so would eliminate analyses of family labor supply decisions as well as labor supply decisions in the context of the life cycle. The essential features of the decision to work for pay are included in Chapter 6. as well as the general location of their employment.Arbitration and the Bargaining Contract Zone 2 . and Ethnicity in the Labor Market Appendix 12A .Compensating Wage Differentials and Layoffs Chapter 9 .Supply of Labor to the Economy: The Decision to Work Chapter 7 .Investments in Human Capital: Education and Training Appendix 9A . the Family.Labor Supply: Household Production.Unions and the Labor Market Appendix 13A . Immigration. prospective workers encounter important choices concerning their occupation and industry. Chapters 6 and 7 are designed to be self-contained for the convenience of instructors who wish to teach labor supply ahead of labor demand.

we now move to analyses of special topics: compensation.Chapter 14 . discrimination. The chapters on unionism (Chapter 13) and discrimination (Chapter 12) deal with issues typically covered in labor economics courses. inequality. and unemployment. and these chapters are built upon the preceding ten.Unemployment Having presented basic concepts and analytical tools necessary to understand the demand and supply sides of the labor market. however. The chapter on inequality is unique and can be skipped without a loss in coverage of conventional material. but they are more comprehensive than most other texts. it is written in a way that provides a review of material in previous chapters. No new analytical tools are introduced in these chapters. unions. A complete analysis of all these topics requires an understanding of behavior on both the demand and supply sides of the market.Lorenz Curves and Gini Coefficients Chapter 15 . 3 .Inequality in Earnings Appendix 14A . It should be noted that the appendix to Chapter 12 includes an application of regression analysis.

At times. 3. The basic purpose of Chapter 1 is to introduce students to the two major modes of economic analysis: positive and normative. 2. and an example of the behavioral predictions flowing from such a model is presented. though. the concept of rationality is defined and discussed. The discussion of normative economics emphasizes its philosophical underpinnings and includes a discussion of the conditions under which a market would fail to produce results consistent with the normative criteria. 4. The appendix to Chapter 1 introduces the student to ordinary least squares regression analysis. the goal of improving Pareto efficiency conflicts with one of generating more equity. and underlying this theory of behavior are the basic assumptions of scarcity and rationality.CHAPTER 1 . the "error term." and theories of social optimality are based in part on the underlying philosophical principle of "mutual benefit. and the execution of contracts. the exchange of information. The concept that governmental intervention in a market may be justified on grounds other than the principle of mutual benefit is discussed (for example. introduced in a graphical context. A governmental policy is "Pareto-improving" if it encourages additional mutually beneficial transactions. as is the underlying concept of scarcity.INTRODUCTION Because the textbook stresses economic analysis as it applies to the labor market. " 5. Normative economics is the study of what "should be. and there are three common reasons for such failure. The uniqueness of labor services affects the characteristics of the labor market. a lengthy discussion of what an economic model is. 7. students must understand the ways economic analyses are used. List of Major Concepts 1." and the t statistic. Positive economics is the study of economic behavior. There is. in addition. Chapter 1 discusses the bases of each mode in some detail. the "intercept" and "slope" parameters. It begins with univariate analysis. 6. The essential features of a market include the facilitation of contact between buyers and sellers. The analysis then moves to multivariate analysis and the problem of omitted variables. A market "fails" when it does not permit all mutually beneficial trades to take place. explaining the concepts of dependent and independent variables. government 4 . Because both modes of analysis rest on some very fundamental assumptions. Labor market examples of governmental remedies are provided. In our treatment of positive economics.

Are the following statements "positive" or "normative"? Why? a. appearance) without getting into the complexities of 5 . and in designing such a building the architect may employ a model that captures the essentials of his or her concerns (namely. c. Employers offering pension benefits will pay lower wages than they would if they did not offer a pension program. (Appendix) A way to summarize a linear relationship between two variables is through ordinary least squares regression analysis -. Employers should not be required to offer pensions to their employees. e. military salaries would probably fall. estimates of the other coefficients may be biased away from their true values.. Answer: (a) normative (b) positive (c) positive (d) normative (e) positive 4. If the military draft were reinstituted. In this sense an economic model is analogous to an architect's model of a building. 11.g. 10. b. An architect may be interested in designing a building that fits in harmoniously with its surroundings. and the uncertainty surrounding these estimates are summarized by the standard error of the estimate. wages and quit rates) can be plotted graphically. (Appendix) Multivariate procedures for summarizing the relationship between a dependent and two or more independent variables is a generalization of the univariate procedure. the wages of unskilled immigrants already here will rise. d. What are the functions and limitations of an economic model? Answer: The major function of an economic model is to strip away real world complexities and focus on a particular cause/effect relationship. 8. The military draft compels people to engage in a transaction they would not voluntarily enter into. Answers to Even-Numbered Review Questions 2. (Appendix) If an independent variable that should be in an estimating equation is left out. holding the other variables constant.intervention may be justified on the grounds that income redistribution is a desirable social objective). this visual relationship can also be summarized algebraically. 9. (Appendix) The relationship between two economic variables (e. it should therefore be avoided as a way of recruiting military personnel. and each coefficient can be interpreted as the effect on the dependent variable of a one-unit change in the relevant independent variable.a procedure that plots the "best" line (the one that minimizes the sum of squared deviations) through the various data points. If further immigration of unskilled foreigners is prevented. The parameters describing this line are estimated.

. For example. Ideally. Answer: Laws preventing women from working more than 40 hours per week essentially blocked mutually beneficial transactions. Government also has the power to distort prices by setting minimum wages. The restrictions upon their employment prevented these transactions from occurring and therefore made both the women and their potential employers worse off.4 = 5 dollars per hour. How much is a 20-year-old predicted to earn based on the first estimate? b.01(Ai)2. governments also have power to prevent transactions or distort prices. A few years ago it was common for state laws to prohibit women from working more than 40 hours a week. W = 3 + . if we are interested in bow behavior is affected by stimulus B.3Ai .” Comment. Models used to generate insights about responses to a given economic stimulus are often not intended to forecast actual outcomes. Government regulations can outlaw certain transactions that the parties to them would consider mutually beneficial (the text mentions laws that historically prevented women from working more than 40 hours per week). How much is a 20-year-old predicted to earn based on the second estimate? Answer: a. Similarly. our model may not correctly forecast the observed behavior if stimuli C through E also change. and the design of interior office space. electrical circuits. 6 .. There were women who wanted to work more than 40 hours a week. and so forth. Answer. D. b. A second regression from another group of workers yields this estimate: Wi = 3 + .3x20 . evaluate these laws. where W is the hourly wage rate (in dollars) and A is the age in years. 8. 6. mandating premiums for overtime work.01x20x20 = 3 + 6 . “Government policies as frequently prevent Pareto efficiency as they enhance it. Achieving Pareto efficiency requires the completion of all mutually beneficial transactions. both of which can prevent the completion of mutually beneficial transactions.3x20 = 5 dollars per hour. However. an economic model will often focus on a particular kind of behavior and ignore complexities that are either not germane to that behavior or only of indirect importance. Using the principles underlying normative economics. a.3Ai. and E held constant. with factors C. (Appendix) Suppose that a least squares regression yields the following estimate: Wi = -1 + . Answers to Even-Numbered Problems 2. W = -1 + .plumbing. government would step in to provide information is that is blocking mutually beneficial transactions or to establish markets (or market substitutes) when markets do not exist. and there were employers who wanted to employ them for more than 40 hours a week.

and they have limited capacities to make informed decisions even in the absence of compulsion. Answer. and there are no doubt employees who could be induced – perhaps by higher wages – to work on Sundays. and this can be assured only if the transactions are voluntary and take place with complete information. Answer: Pareto efficiency requires that transactions have mutual benefits. A law in one town of a Canadian province limits large supermarkets to just four employees on Sundays. From the perspective of normative economics. Children may be compelled by their parents to work. Child labor is an issue that has been discussed a lot recently. A law preventing such work prevents a mutually beneficial transaction. 2. 7 . Analyze this law using the concepts of normative economics.Suggested Essay Questions 1. There are no doubt large supermarkets that want to hire workers on Sundays (because there are consumers who want to shop on Sundays). explain the problem with child labor.

and it is the purpose of Chapter 2 to provide that framework. 5. Distinctions between individual and more aggregated demand curves are discussed. primary. 4. The "labor force" consists of those who are employed or who are seeking work. Changes in the industrial and occupational distribution of employment are facilitated by the labor market. and major trends in labor force participation rates are discussed. secondary) are defined. definitions. which also facilitates adjustments to the "birth" and "death" of job opportunities. we discuss basic concepts of demand and supply so that students will be able to see their interaction at the very outset. List of Major Concepts 1. The second aim is to provide students with an overview of labor market analysis. internal.CHAPTER 2 . 8 . we turn to the question of wage determination and wage equilibrium. To this purpose.OVERVIEW OF THE LABOR MARKET Our goal in this text is to move students along very carefully from what they do know to the mastery of new concepts. This chapter has both a descriptive and an analytical purpose. The distinction between nominal and real wage rates is made. We start the overview with a discussion of demand schedules and their corresponding demand curves. It is our belief that students learn most efficiently if they can associate these new ideas with an overall framework. Forces that can alter market equilibria are comprehensively discussed. and the concept of being "overpaid" or "underpaid" (including a discussion of economic rents). external. and the calculation of real wages is illustrated. magnitudes. 2. and the level of (and trends in) labor earnings. 3. local. as is the distinction between short-run and long-run demand curves. The "unemployed" are those who are not employed but are seeking work (or awaiting recall). the distribution of employment. One aim is to introduce students to the essential concepts. The labor market and its various subclassifications (national. unemployment. the chapter discusses and presents data on such topics as the labor force. Particular attention is given to the distinction between movement along a curve and shifts of a curve. the existence of disequilibrium. The chapter ends with a discussion of unemployment across various countries. and the chapter's major concepts are reinforced by discussions of the effects of unions. A similar discussion and set of distinctions are made for the supply side of the market. trends in the unemployment rate are noted. After both the demand and supply sides of the market have been discussed and generally modeled. regional. and trends of widely used labor market descriptors. To this end.

The labor market is one of three major markets with which an employer must deal. the choice of technology.) A fall in the danger of the occupation. when a variable not shown on the graph changes. rather than shifts of. Answers to Even-Numbered Review Questions 2. 9 . 14. and income are depicted graphically. 12. 17. earnings. 11. The interaction of market demand and supply determines the equilibrium wage. demand and supply curves occur when wages of the job in question change. The concepts of shortage and surplus are directly related to the relationship between actual and equilibrium wage rates. and especially long-term unemployment rates. scale and substitution effects are ultimately related to these forces. 15. 10. The concepts of "overpaid" and "underpaid" compare the actual wage to the equilibrium (market) wage rate. Movements along. and the supply schedule of competing factors of production. the curves tend to shift. Distinctions among wage rates. 9.6. Unemployment rates. Disequilibium will persist if the wage is not allowed to adjust to shifts in demand or supply. labor market outcomes (terms of employment and employment levels) are affected by both product and capital markets. 7. 8. Distinctions between individual and market demand and supply curves are discussed. Changes in the equilibrium wage rate are caused by shifts in either the demand or supply curves. this rise may reflect the existence of relatively stronger nonmarket forces in Europe. The concepts underlying a labor demand schedule are associated with product demand. b. total compensation." 16. in turn. 13. have risen in Europe relative to the United States and Canada over the recent decade. Underlying a supply schedule for labor are the alternatives workers have and their preferences regarding the job's characteristics.) An increase in product demand. Individuals paid more than their reservation wage are said to obtain an "economic rent. Analyze the impact of the following changes on wages and employment in a given occupation: a.

should increase the attractiveness of that occupation. their relationship to the prices of both consumer and producer products is of ultimate importance. the supply curve to the given occupation will shift left and tend to drive up wages. The demand for labor is in part derived from product demand. 6. other things being equal. If those opportunities become more attractive. how would this market adjust? Answer: Starting from the position of equilibrium.) Increased wages in alternative occupations. What. The real wage rate can fall when the nominal wage rate is rising if prices of consumer and producer products rise even more quickly. (b) An increase in product demand will shift the demand for labor curve to the right causing both wages and employment to increase. This will cause employment in this market to fall and wages to rise. How will a fall in the civilian unemployment rate affect the supply of recruits for the volunteer army? What will be the effect on military wages? Answer: Supply curves to a given occupation are drawn holding alternative opportunities constant. While market wages are usually stated in nominal terms. Suppose that the Consumer Product Safety Commission issues a regulation requiring an expensive safety device to be attached to all power lawnmowers. the prices that will be charged to consumers will rise. Therefore. the end result is a leftward shift of the labor demand 10 . With less product demanded for any given wage rate paid to workers. This price increase will move the firm upward and to the left along its product demand curve.c. This device does not increase the efficiency with which the lawnmower operates. 8. Answer: (a) A fall in the danger of the occupation. 4. a fall in the unemployment rate will shift the army's supply curve to the left (there will be fewer recruits at each army wage rate). Thus. and the army's wages will be driven up. Because it is more costly now to manufacture lawnmowers. both parties to the employment relationship are. shifting the supply curve to the right and causing employment to rise and wages to fall. in the last analysis. Answer: This regulation would cause the demand for labor curve of the firms that manufacture power mowers to shift to the left. if anything. Suppose a particular labor market were in market-clearing equilibrium. concerned with the real wage rate. does this regulation do to the demand for labor of firms manufacturing power lawnmowers? Explain. (c) Increased wages in other occupations will render them relatively more attractive than they were before and cause the supply curve to the occupation in question to shift to the left. What could happen to cause the equilibrium wage to fall? If all money wages rose each year. a labor market could experience a fall in the equilibrium wage if either the demand curve shifts to the left or the supply curve shifts to the right.

000 – 150W. Why doesn't employment grow by 20. Plot the new supply curve and find the new wage and employment level. Suppose we observe that employment levels in a certain region suddenly decline as a result of (i) a fall in the region's demand for labor.) 10. drawing a line using these two points gives us the demand curve. However. a. however. is it likely that employment in the region will recover? Explain. employers desire 25.000 workers (Ld = 100.000 + 350W and the demand curve for school teachers is Ld = 100. See the figure. Suppose that the supply curve for school teachers is Ls = 20. Since the equation above is for a straight line.000? Answer: a. consumer preferences for greater safety were to shift the product demand curve to the right. employment in the region would recover to its prior level (assuming no subsequent shifts in demand or supply curves) only if the supply curve was vertical.000. Use the same procedure for the labor supply curve. if supply curves are upward-sloping. 11 . where L = the number of teachers and W = the daily wage. If W = 500.000 more workers are willing to work as school teachers. if W = 400. b. This decline in employment is larger than the ultimate decline in employment. Plot the Ld and Ls curves by solving for desired employment at given wage rates.curve. for example. Answer: The initial response to a leftward shift in the labor demand curve in the context of fixed wages is for there to be a relatively large decline in employment. If the new demand for labor curve remains unchanged for a long period and the region's labor supply curve does not shift. they would desire 40.000 – 150x500). (If. the declining wage will cause some withdrawal of labor from the market and employment will not recover to its prior level. What are the equilibrium wage and employment level in this market? c. Now suppose that at any given wage 20. employment losses would be mitigated. Plot the demand and supply curves. The initial disequilibrium between demand and supply in the labor market should force wages down in the long run. and as wages decline firms will move downward along their labor demand curves and will begin to employ more labor. and (ii) wages that are fixed in the short run. Answers to Even-Numbered Problems 2.

L = 82. The new labor supply curve is Ls' = 40.b. Plugging W = $160 into both the labor demand and supply equations shows that L = 76. solve for the wage at which the quantity of labor supplied equals the quantity of labor demanded: Ls = 20. Solve for W by adding 150W to both sides and subtracting 20.000 schoolteachers. 12 . Employment doesn't grow by 20.000 school teachers.000 from both sides to yield 500W = 80. To find the equilibrium.000 because the shift in the supply curve causes the wage to fall. which induces some teachers to drop out of the market.000 + 350W = 100. c.000. Assume this movement takes the form of boycotting items made under sweatshop conditions.000 + 350W. Setting this equal to Ld and solving shows that W = $120 per day. Dividing both sides by 500 reveals that W = $160 per day. Suggested Essay Questions 1.000 – 150W = Ld. American students have organized opposition to the sale by their campus stores of university apparel made for American retailers by workers in foreign countries who work in “sweatshop” conditions (long hours at low pay in bad working conditions).

S. what must these actions include to ensure that the workers they are unambiguously better off? Answer. students in the U. (b) Assuming that actions by American students are the only force driving the improvement of wages and working conditions in foreign countries. With a fixed demand curve. Outlawing child labor on banana plantations reduces the supply of labor to these plantations. (b) To avoid the effects in (a). must be willing to buy the same quantity and quality of apparel at higher prices – that is. 13 . Assume Ecuador now outlaws the use of child labor on banana plantations.(a) Analyze the immediate labor market outcomes for sweatshop workers in these countries. using demand and supply curves to illustrate the mechanisms driving this outcome. 2. which are grown and harvested by a large labor force that includes many children. Ecuador is the world’s leading exporter of bananas. Answer. Using economic theory in its “positive” mode. Use demand and supply curves in your analysis. this shift in the supply curve drives up wages and drives down employment. This drives down wages and employment (assuming a fixed supply curve). (a) The demand curve for low-wage workers in foreign countries shifts to the left when the product demand for the apparel they made falls. analyze what would happen to employment and wages in the banana farming industry in Ecuador. they must be willing to pay a premium for apparel made by betterpaid workers. shifting the supply curve to the left.

The principal conceptual tool employed involves distinguishing between the wage rate employers pay and the wages employees receive.THE DEMAND FOR LABOR This chapter studies the downward sloping nature of the labor demand curve. When these two wages differ. and it moves deductively from the assumption of profit maximization to the marginal conditions with respect to labor. When a payroll tax is introduced. The process of profit maximization requires considering small changes in inputs (or outputs). we contrast the wage and employment effects of "market" and "mandated" shifts in the labor supply curve. firms perceive prices as given. The difference between the short-run and long-run depends on the fixity of capital. These conditions are expressed in simple mathematical terms. 4. List of Major Concepts 1. we first consider the short-run before moving on to the long-run and the case with more than two inputs. holding capital constant. Both substitution and scale effects are graphically illustrated. The chapter concludes with a policy analysis of payroll taxes that demonstrates the insights that can be derived from an understanding of the demand for labor. It begins with a section that discusses profit maximization. If markets are competitive. The analysis of demand begins with the assumption that both labor and product markets are competitive. and then move to an analysis of demand when the labor market is monopsonized. In the latter context. The appendix to Chapter 3 is designed for students who feel comfortable using microeconomic theory at the intermediate level. Any instructors wishing to skip over the appendix can do so without loss of concepts needed to understand the basics of the demand for labor. and there will be related changes in both wages and employment. one must be stated in terms of the other for the demand and supply curves to be shown together. in this context. 14 . and the assumptions underlying the demand curve are more rigorously presented. The marginal product of labor is the added output generated by adding a unit of labor. and comparing the marginal revenue generated by an additional input with its marginal expense. one of the two curves must therefore shift. Additional insights into the marginal productivity theory of demand are provided in a section discussing common objections to this theory of demand. 2. Next we consider the demand for labor when the product market is not competitive. We derive the demand for labor graphically using a two-factor model in both the long-run and short-run. The assumption of profit maximization by firms underlies the theory of labor demand. 3.CHAPTER 3 . and they are also discussed verbally.

15. 12. the demand for one grade of labor is influenced by the wages of other grades of labor. The imposition of payroll taxes on the employer will shift the demand for labor curve (when drawn as a function of employee wages) to the left. Two principal objections to the marginal productivity theory of labor demand are presented and discussed. and gross complements are defined and related. 10. 13. 11. (Appendix) The demand for labor in the short-run is graphically derived. The relationship between the demand curve of individual firms and the market demand curve is briefly discussed. however. and adjustments of capital to changes in relative prices generate substitution effects on employment. at least in the short-run.5. The conditions for profit maximization with respect to capital are relevant in the longrun. The concept of diminishing marginal productivity is discussed. 6. Mandated wage increases. Generalizing to more than two inputs. The reason for this derives from the upper-sloping labor supply curve facing the individual firm. employment. 14. In the context of monopsony. 15 . 7. The concepts of substitutes in production. and the resultant increase in the marginal expense of labor above the wage rate. Monopsony in the labor market affects wages. 16. complements in production. The demand for labor can be stated in terms of either the real or the nominal wage. and thus. wage increases accompanying market shifts (to the left) in the labor supply curve produce the conventional expectations of decreased employment. causing worker wages and/or employment levels to fall. (Appendix) The graphical depiction of a production function is presented. and the labor conditions for profit maximization. 8. 9. leading to ambiguous expectations regarding employment changes. Product market monopoly affects the profit maximization conditions. gross substitutes. The relationship between the demand for labor curve and the downward sloping portion of a firm's marginal product of labor curve is analyzed. 18. the demand for labor. 17. flatten the labor supply curve and reduce the marginal expense of labor.

market clearing wage and employment levels will be W0 and E0.S. Answer. Suppose the government were to subsidize the wages of all women in the population by paying their employers 50 cents for every hour they worked. 16 .8c). Suppose that prisons historically have required inmates to perform. pay is an important consideration. in the absence of any subsidy. Would you expect to see any differences in the technologies used to perform these tasks? Explain. various cleaning and food preparation jobs within the prison. In choosing employers. 6. and that the cleaning and food preparation tasks are now performed by non-prisoners hired to do them. Conversely. without pay.19. showing both substitution and scale effects of a wage change. S0. and that workers are really trying to maximize utility. D0. If some of the latter are forced into the military. and the supply curve. When wages rise. When inmates were required to work without pay.) Answer: Consider a simple competitive labor market in which the demand and supply of women are both expressed in terms of the wage received by women (which. What would be the effect on the wage rate women received? What would be the effect on the net wage employers paid? (The net wage would be the wage women received less 50 cents. respectively. it will lose less civilian output than it would by drafting an equal number of civilian workers randomly. many of those who choose to remain civilians are workers whose civilian pay is higher than their military pay offer. Because profits are maximized when workers’ marginal revenue productivities (MRPL) are equal to the wage (W). and we expect prisons to adopt the use of more capital in the production process. military is having difficulty recruiting volunteers and is considering one of two options: raising pay or reinstating the draft system. when society relies on military volunteers. Suppose that the U. we can assume that those with higher pay also have higher civilian MRPL. Those who choose civilian life over the military will be those who would get the least utility from performing military duties. (It should be noted that pay is not the only consideration in choosing a job. their wage was essentially zero – and we would expect that prisons to have adopted labor-intensive technologies (using the argument inherent in equation 3. Answer. (Appendix) The demand for labor in the long-run. Thus. there is also an opportunity cost to society of lost worker utility!) 4. many of those who choose a military job are those whose civilian job opportunities pay less than the military. is assumed to be equal to the wage paid by employers). Answers to Even-Numbered Review Questions 2. Given the demand curve. Now suppose that prisoners are offered paid work in factory jobs within the prison walls. the cost of expanding output using labor becomes greater. Analyze the opportunity costs of lost civilian production when volunteers are used as compared to those associated with drafting civilians using some random method of choice. is graphically illustrated. Thus.

Downward pressure would be placed on the wage paid by employers and it would fall by less than 50 cents (as long as labor supply was responsive to the wage). In 1999. manufacturing worker were $19. Indeed.S.S.S. If supply and demand curves are drawn in terms of this variable. Recognizing that the analysis leading up to equation 3.e. 8. It is important to stress to students that one would reach identical conclusions if one analyzed the subsidy in terms of the wage employers pay. exceeds the number who are willing to work.Suppose the government now subsidizes employers by paying them 50 cents for every hour women work.8c can be used to understand the choices firms make between any two factors of production. This equilibrium occurs at the wage rate W1. Bureau of Labor Statistics reported that hourly compensation costs per U.S. the wage received by women would rise by 50 cents less the fall in the wage paid by employers. At the old market clearing wage received by women. E2. Viewed in terms of the wage received by women. At the old wage paid by employers. and Mexican workers to be substitute factors of production. the more responsive labor supply is to the wage rate. and this wage rises until the excess demand for labor is eliminated. and the employment level E1.20..) 17 . Since the wage paid by employers now equals the wage women receive less the 50-cent subsidy. E0. W0. while those in Mexico were $2. the supply of female labor would now exceed the demand. the U. might still expand its output using U. As a result. This puts upward pressure on the wage received by women. as long as labor supply is responsive to wages).S.12. explain why a growing firm with facilities in both Mexico and the U. the number of women employers want to hire. a 50-cent-an-hour subsidy for women would shift the female labor supply curve down by 50 cents. (Hint: consider U. workers. the employers' demand curve will shift up by exactly 50 cents (reflecting the fact that this amount will be paid by the government). It is clear from the figure that the wage received by women increases by less than 50 cents as long as the supply of labor curve is not vertical (i. the less the women's wage will rise. it is also clear that the wage paid by employers declines (by 50 cents minus the increase in the wage women receive).

Answers to Even-Numbered Problems 2. The marginal revenue is the number of additional units produced times the price of output. In choosing between U.000 14.200 20. where L = the number of workers.S.50x700 = $350 $.5L = 10 when L = 20 4. The factory sells its output for $. The firm needs to compare the marginal cost to the marginal revenue of hiring an additional supervisor. workers. To do so.500 20. The daily wage of supervisors is $500 but output rises as more supervisors are hired. as shown below.S. The marginal cost is always $500 for each extra supervisor. even though wages are lower in Mexico. Number of Supervisors 1 2 3 4 5 MC $500 $500 $500 $500 $500 MR $. 20 .50x3800 = $1900 $..600 Answer. The output of workers at a factory depends on the number of supervisors hired (see below). The marginal revenue product of labor in the local saw mill is MRPL = 20 . If the wage of saw mill workers is $10 per hour.S..8c). and needs to decide how many supervisors to hire. profit maximization means that firms will substitute one for another until the ratio of their wages to their marginal productivities are equal.50x400 = $200 18 . The profit-maximizing firm will choose to expand production in the least costly way. firms would decide to expand output using U.50 each. it hires 50 production workers at a wage of $100 per day.50x3200 = $1600 $.Answer. How many supervisors should it hire? Supervisors 0 1 2 3 4 5 Output (units per day) 11.5L.50x1500 = $750 $. workers. but if the relative marginal productivity of Mexican workers is even lower.. and Mexican workers.S. then how many workers will the mill hire? Answer: The mill will hire workers until MRPL = W. Put differently.800 18. it will continue to substitute one factor of production for another until the costs of expanding production using the two factors are equal (see equation 3. Mexican wages may be much lower than in the U. the ratio of wages to marginal productivity – which is the critical datum – could be higher there than in the U.000 19.

Does this mean that keyboarding jobs in the United States will be lost to India? Explain. other things equal. 19 . Assume that wages for keyboarders (data entry clerks) are lower in India than in the United States. Answer. “Despite free trade and the need to compete with American and Canadian manufacturers. economic theory leads us to expect that firms would use labor-intensive methods to produce. does this indicate that. However. When wages are low and capital is costly. increased costs of manufacturing university apparel also would be expected to reduce sales and the scale of output. American students have organized opposition to the sale by their campus stores of university apparel made for American retailers by workers in foreign countries who work in “sweatshop” conditions (long hours at low pay in bad working conditions).” If true. which will put downward pressure on employment in the American apparel and retailing industries. 3. Answer. If this movement is successful in raising pay and improving working conditions for apparel workers in foreign countries. marginal productivity is also critical. plant owners there are making mistakes? Answer.The firm will hire three supervisors since the marginal revenue generated from hiring the third supervisor exceeds $500 but the marginal revenue generated from hiring the fourth supervisor is less than $500. Suggested Essay Questions 1. how will these changes abroad affect labor market outcomes for workers in the apparel and retailing industries in the United States? Explain. The presence of both substitution and scale effects – working in opposite directions – implies that the ultimate effect on American workers in these industries cannot be predicted by theory alone. Thus. then there will be incentives to substitute for these foreign workers (with capital or workers elsewhere. most Mexican factories continue to use outdated equipment and inefficient (labor-using) work systems. including the United States). The choice of technology is affected by the marginal costs of producing using labor (W/MPL) compared to the marginal costs of producing using capital (C/MPK). in the face of very low wages in Mexico. If increased labor costs abroad are not accompanied by increases in marginal productivity. Indian data entry clerks will be substituted for American ones only if the ratio of their wage to their marginal productivity is lower. 2. it is not wage alone that affects the incentives to substitute.

5. Standard labor demand theory predicts that an increase in the minimum wage will result in the loss of employment. Here we stress the concepts of gross substitutability and gross complementarity (as distinguished from substitutes or complements in production). The concepts of gross substitutability and gross complementarity are defined and distinguished from substitutability or complementarity in production. Another section is devoted to a discussion of the empirical evidence on both the own-wage elasticity of demand and cross-wage elasticities. The own-wage elasticity of demand is the percentage change in employment of a class of labor induced by a one-percent change in the wages of that class. 6. 7. Empirical evidence concerning the own-wage and cross-wage elasticities of demand. and that the presence of uncovered sectors and intersectoral shifts in product demand be built into the design of the study. that other things influencing employment levels be controlled for.CHAPTER 4 . In this regard the Hicks-Marshall laws of derived demand are explained. based on both statistical studies and inferential analyses. they may be positive or negative. is presented. Chapter 4 deals with the magnitude of the employment response to a change in the wage rate. with each of the four laws being related to the substitution and scale effects (concepts that were introduced in Chapters 2 and 3). we move to a discussion of the cross-wage elasticity of demand. The four Hicks-Marshall laws of derived demand are introduced and related to the substitution and scale effects of a wage change.LABOR DEMAND ELASTICITIES While Chapter 3 dealt with the downward sloping nature of labor demand curves. 2. The appendix to Chapter 4 analyzes the labor-market effects of international trade. After discussing the laws of derived demand in the context of own-wage effects. List of Major Concepts 1. 3. Cross-wage elasticities of demand are the percentage change in employment of a class of labor induced by wage changes in another class. 4. Actually measuring the employment effects of minimum-wage increases requires that we distinguish between nominal and real changes in the rate. 20 . The chapter concludes with sections that apply the concepts of demand elasticity to analyzing the effects of minimum-wage legislation and technological change. We begin the chapter by defining and discussing the own-wage elasticity of demand.

in attempting to analyze the likely dominance of the substitution or scale effect in this case.000)/20. Which union faces the more elastic demand curve? b. Its elasticity over the interval $4. 12.00 or (-1)/(1/5) or -5. the elasticity of demand for labor is not necessarily a constant along a given demand curve.00 is given by (20.00)/5.00-4. it is not true that trade will cause permanent job loss in high-wage countries. but they might also derive from labor markets that are characterized by monopsonistic behavior (for which theoretically expected short-run employment effects of mandated wage increases are ambiguous). when we speak of changes in wage rates that are not infinitesimal. or (1/2)/(-1/4).000 person hours.00 to $5. which equals -2. union A's elasticity when one increases its wage rate from $4. with some studies finding the "conventional" negative effects and some finding none. The labor-demand effects of technological improvements in capital depend on crosselasticities. when one decreases union A's wage from $5. Union A faces a demand curve in which a wage of $4 per hour leads to demand for 20. 10. Indeed.000)/10. 9. the Hicks-Marshall laws applicable to own-wage changes cannot be slavishly applied. Union B faces a demand curve in which a wage of $6 per hour leads to demand for 30.00-5. 13.000 person hours. (Appendix) International trade is based on comparative advantage. while a wage of $5 per hour leads to demand for 33. Technological change causes total employment to be reallocated. Given the data on union A and the formula for the elasticity of demand.000 person hours. Which union will be more successful in increasing the total income (wages times person hours) of its membership? Answer: (a) As noted in the text.00.000 divided by (5. Answers to Even-Numbered Review Questions 2.00 depends on which wage we use as a base. its elasticity is given by (10. %E/%W.8.000-10. the actual value of the elasticity depends on the wage rate from which one is starting.00 to $4. 21 . 11. Technological change in product markets can change the slope and placement of product demand curves.00)/4. not permanently reduced.000-20. The results of studies estimating the effects of minimum-wage increases are sensitive to the specification employed. In contrast. a. It is possible that the generally small effects of minimum-wage increases are the result of the studies' focus on short-run effects.000 person hours and a wage of $5 per hour leads to demand for 10. Even those studies with negative employment effects generally find labor demand elasticities that are much smaller than those summarized earlier in the chapter. thereby shifting and/or changing the elasticity of labor demand curves.000 divided by ($4.00.00 to $5. and while trade may shift employment across industries.

the labor demand curve clearly shifts to the right. however. (This answer assumes that wage/employment contracts under collective bargaining lie on the demand-for-labor curve. so we cannot tell in advance which effect will dominate. work force -. However.5(E1.000-30.50] = (2/3)/(-2/9) = -3 Elas.000-10. 22 . In the present question the average elasticities for union A and union B are given by Elas. including the bargaining power of the two unions and the firms with which they deal.00)/4.+E2)]/[(W2-W1.50] = -. (B): [(33.To prevent this type of result. economists often define the average elasticity over the wage interval W1. one's inclination is to say that the union facing the less elastic demand curve is likely to be more successful in raising its members' wages.S. Concern has been expressed that computerization and office automation will lead to a substantial decline in white-collar employment and increased unemployment of clerical workers. this need not always be the case.00-5.00)/5.000]/[(4.over 15 percent in recent years.)/. that the union with the more elastic demand curve will suffer a larger percentage employment loss for any given percentage increase in wages. there is also a scale effect tending to increase employment for the above categories. As shown in the appendix to Chapter 12.) 4.000)/15. to W2 as [(E2-E1. tending to shift the labor demand curve to the left for categories of labor that are substitutes in production with capital. It is true.+W2)].00-6. Note that this elasticity estimate does not vary with the end of the wage interval (high or low) at which one starts.)/. This depends upon a number of factors.000)/31. union A faces the more elastic demand curve. (A): [(20.524 Given the above data. Thus. Is this concern well founded? Answer: Offices have become more computerized in recent years because the cost of using computers has fallen relative to labor's price (the wage rate). it is not necessarily true that white-collar employment will fall.) Therefore.500]/[(5. (For labor categories that are complementary with capital in the production process. (b) One cannot say which union will be more successful in increasing its members' total earnings. if it is difficult to substitute capital for labor. This causes a substitution effect.5(W1. and if the share of capital in total cost is large). and this is likely to reduce its incentive to push for large wage gains. Clerical workers represent a substantial share of the U. the scale effect may prevail for many of these jobs (a dominant scale effect is more likely if product demand is elastic.

using your knowledge of a) the definition of the own-wage elasticity of labor demand. this substitution will tend to shift the labor demand curve for factory workers to the left. and knitting in their homes. Do you concur with Professor Pessimist? Answer. what effect will repealing the prohibitions have on the labor demand curve for factory workers in the garment industry? Answer : Repealing the prohibitions enables garment manufacturers to substitute home workers for factory workers. Answers to Even-Numbered Problems Ed: the answer to problem 2 is to be changed: 2. b) the magnitude of this elasticity for the economy as a whole. Professor Pessimist argues before Congress that reducing the size of the military will have grave consequences for the typical American worker. there may be a favorable scale effect for certain factory workers performing tasks (such as packaging and shipping) complementary with home production. In this case Ld = 1 million. Own-wage elasticity of demand for labor = %(quantity demanded)/%(wage) = (Ld/Ld)/(W/W). Assuming that the 1942 regulations were constraining. However. one can presume that there will be at least some substitution of home workers for factory workers. but only if wages are rigid and employees refuse to shift to lower paying jobs will their unemployment be permanent. First. unemployment will not be the long-term result unless wages are rigid. and the own-wage elasticity of demand for labor is 23 . stitching. so that clothing items may now be made either by workers in factories or by independent contractors doing work in their homes. Ld = about 135 million employed workers. He argues that if one million individuals were released from the military and were instead employed in the civilian labor market. Because you were asked about the effects on civilian wages as a whole. and c) the size of civilian employment in comparison to this flood from the military. Adversely affected workers would have to shift to other occupations and may experience some transitional joblessness. 6. so too will the ability to substitute home labor for factory workers. Besides the shift to the left of the labor demand curve. the new substitution possibilities opened up by repealing the 1942 regulations should serve to make the labor demand curve for factory workers more elastic. draw a simple diagram depicting the effect of this influx of workers from the military.Even if labor demand shifts left for a particular occupational category. Just as the greater ability to substitute capital for labor will tend to make the labor demand curve more elastic. graph these events and estimate the magnitude of the reduction in wages for civilian workers as a whole. Next. average wages in the civilian labor market would fall dramatically. you will probably not concur with Professor Pessimist. If these prohibitions are repealed. Assume that the demand curve for civilian labor does not shift when workers are released from the military. In 1942 the government promulgated regulations that prohibited the manufacture of many types of garments by workers who did the sewing.

and a scale effect that tends to reduce employment. Factors that minimize the extent of job loss are those that make for a robust substitution effect and a small scale effect. the military recruits in a very narrow segment of the labor market-mostly high school grads who do not attend college.approximately -1. in this age group.74 percent. This proposal is an attempt to monitor truck drivers. 2. Thus. and it really raises the cost of labor (trucks now require both a driver and monitoring equipment). This implies that wages will fall by 0. Suggested Essay Questions 1. Thus. A small scale effect would be created if natural gas is a small part of the overall cost of production. Where it is easier to substitute capital for labor. then trucks will tend to get bigger and the number of drivers 24 .about -1/135 (or -0. Discuss how implementing this proposal is likely to affect the demand for truck drivers. the four factors underlying the elasticity of labor demand are relevant. The production possibilities curve for France is also linear and allows it to produce a maximum of 250 million units of clothing or 150 million units of food. 4. so neither has a comparative advantage in either good. What conditions would minimize the extent of manufacturing job loss associated with this price increase? Answer. One anti-terrorism expert proposes the development of two capabilities that would protect shipments of hazardous materials by truck. If there were only 13. downsizing would have the greatest effect on this segment of the market. Which good will the United States export to France? Answer: Neither. However.0074). and if the demand for the products made using natural gas is relatively inelastic. A higher price of natural gas will have a substitution effect that could favor increased employment. and if the supply of labor is relatively elastic. This question involves the cross-elasticity of demand. The public utilities commission in a state lifts price controls on the sale of natural gas to manufacturing plants and allows utilities to charge market prices (which are 30% higher). (Appendix) The production possibilities curve for the United States is linear and allows it to produce a maximum of 500 million units of clothing or 300 million units of food. -1 = (1 million/135 million)/(W/W). A large substitution effect will tend to occur if labor is easily substituted for natural gas in the production process. Thus.4% on this group of the population.5 million. Answer. One is to maintain continuous satellite monitoring of all such shipments. a labor demand elasticity of –1 would yield a wage effect of the military downsizing of closer to –7. noting especially the conditions under which this effect is likely to be largest. so W/W will be very small -. The two countries have the same opportunity cost. and who are between ages 17-21. say. and the other is to install devices that automatically shut down any truck that has been hijacked or deviates from its approved route.

to specialize in goods for which they have a comparative advantage). Free trade allows countries to specialize in producing goods and services that have the lowest internal opportunity cost (that is. it must have a comparative disadvantage in the production of agricultural goods. by the definition of opportunity cost. jobs in Mexican agriculture have been destroyed while jobs in the industrialized cities of northern Mexico have expanded. the assumed facts in the question are quite consistent with economic theory. where the monitoring equipment represents a larger share of overall cost. the scale effect will be larger. are they consistent with economic theory? Answer. the scale effect will be larger and product demand will go down more. If Mexico has a comparative advantage in the production of manufactured goods. One observer of the North American Free Trade Agreement (NAFTA) claims that.needed will go down more. Assuming the facts on job loss and employment gains are accurate. 25 . The substitution effect will also be larger if the supply of capital (in the form of larger trucks) is elastic. 3. If product demand is more elastic. become less efficient in the production of agricultural goods. If we think of two generalized goods (agricultural goods and manufactured goods). contrary to expectations. Finally. (Appendix). a country becomes more efficient in the production of manufactured goods will. Thus.

QUASI-FIXED LABOR COSTS AND THEIR EFFECTS ON DEMAND This chapter is designed to analyze the effects of quasi-fixed costs on the demand for labor. We begin the chapter with a descriptive section on the magnitude and growth of nonwage labor costs. and we also introduce the concept of hiring and training costs. The fourth and fifth sections offer detailed analyses of the two principal types of labor investments: training investments and hiring investments. One implication of the existence of both variable and quasi-fixed labor costs is that there arises a trade-off between increasing employment through hiring added workers and increasing employment through hiring workers for longer hours. While the firm hopes to recoup the investment over a period it expects the worker to be with the firm. In this particular case. Again.) 26 . we wanted to maintain the organizational overview in the minds of the students.CHAPTER 5 . In the third major section we move from a general discussion of quasi-fixed labor costs to an in-depth analysis of one particular kind of quasi-fixed cost: firms' labor investments. it is our belief that this introduction to human capital theory in Chapter 5 is useful. the student is better able to learn the insights that economics has to offer. An investment is a type of expenditure that occurs primarily in some initial period and then does not recur. In this chapter. This trade-off is discussed in the second section of the chapter. we deliberately chose to spread the concepts of human capital theory across different chapters--using these concepts as necessary and maintaining the overall substantive organization of the text (built around demand and supply). the cost of investment becomes a "sunk cost. we introduce particular concepts or tools as they are called for by the larger context of analysis. the section on hiring investments includes a discussion of credentials and signaling. These topics are also discussed elsewhere in the text (notably in Chapters 11 and 12). For similar reasons." This section analyzes the implications of these labor investment characteristics for the demand for labor (after first introducing the concept of present value and modeling the labor investment decision by the firm). In the section on training investments the student is introduced to the notion of general and specific training. In this section we discuss employee benefits (not all of which are quasi-fixed in nature). as well as to the implications of training investments for the demand for labor. as throughout the text. as well as an introduction to the concept of internal labor markets. and the importance of distinguishing between employment and hours is highlighted in our policy analysis of the overtime pay premium and mandated benefits for part-time workers. because by maintaining a clear view of the overall context of analysis. While Chapter 9 also covers aspects of education and training. (We also firmly believe that discussing concepts or phenomena in several contexts and at different points in the book reinforces the learning process. but we felt that a complete discussion of the effects of quasi-fixed costs on the demand for labor was impossible without a discussion of these concepts. because the quasi-fixed costs of labor are generally nonwage in nature.

List of Major Concepts 1. The multi-period demand for labor. Increased overtime pay premiums that might be required under the Fair Labor Standards Act would tend to reduce the use of overtime. 4. The presence of hiring costs induces firms to use credentials and internal labor markets in the recruiting. The distinction between variable and quasi-fixed labor costs is made. The distinction between general and specific training is defined. 3. 11. but whether they increase the number of workers employed depends on the size of the reduction in total labor hours demanded. Like training costs. There are both explicit and implicit costs of job training. Employee benefits are categorized and the types typically received are listed. and they are recouped by paying wages less than productivity. 6. The presence of quasi-fixed costs causes an employment/hours trade-off. and the firm must determine its optimum mix of employment and hours per worker. 9. 7. hiring investments increase the productivity of selected job applicants (by distinguishing among them on the basis of productivity). 10. Training investments are recouped through the creation of a "surplus" (a gap between marginal product and wage) that also cushions the worker from layoffs over the business cycle. 8. the way this demand is affected by investment costs in the initial period of hire. 13. and the effects of specific training on the relationship between wages and marginal productivity is analyzed. 5. the principal types of labor investments that firms undertake relate to training and hiring. The relative growth of wage and non-wage costs is presented. The essential characteristic of an investment is that resources are expended in the current period and returns are received later. The concept of present value and the need for discounting when economic decisions are made in the context of several time periods are discussed. 27 . and the way investment costs alter profitmaximizing conditions with respect to labor are all generalizations of the singleperiod analysis in Chapter 3. 12. 2. selection and promotion processes.

being sure to define what you mean by short-run and long-run! Answer. Suppose that after training. so it is advantageous for the company to continue employing workers it has already trained. Suppose that the United States adopts a policy requiring employers to offer 600 hours of paid leave for mothers of newly born babies. 4. this will induce firms to (a) hire fewer workers. wages are set at $5 below marginal productivity. as they are in industry X. The decline in employment will stop when the marginal revenue product of labor is once again $5 greater than the wage rate. and the company calculates that to recoup its investment costs the workers’ wages must be $5 per hour below their marginal productivity. When plants close. marginal revenue product still exceeds wages by $3 per hour. Thus. Employment will fall as the firm fails to replace those who leave. The company is not making back enough to make the training be a good investment. but making back $3 per hour is better than laying off the workers and making back nothing! Thus. workers will not be laid off. the firm will not hire and train new workers under the current circumstances. Firing costs are quasi-fixed. and that firms in the industry now have a greater probability of closing than they used to have. When they are increased. when the company is deciding about investing in new workers). the $3 payback per hour is not sufficient to justify the training investment if wages remain as they are. If the company does not feel it can lower wages or employee benefits. and (b) work those they hire for more hours.Answers to Even-Numbered Review Questions 2. and (b) their average hours of work? Answer. 6. Answer: This policy clearly increases the expected cost of employing women of childbearing age by imposing on employers a quasi-fixed cost (equal to 600 hours of 28 . helping them find other jobs. so all that is variable is the employment levels of trained workers). Assuming wages remain the same. including processing necessary forms. how will its employment level be affected in the short-run? How will its employment level be affected in the long run? Explain. analyze the labor demand effects of mandated paid child-care leave on women of childbearing age and on women past childbearing age. In the long run (that is. not hours of work. and the decline in employment will eventually serve to raise the marginal productivity of labor. How might this change affect (a) the number of employees hired in the industry. firms usually must incur various costs associated with laying off its workers. but that developments in the product market quickly (and permanently) reduce marginal productivity by $2 per hour. Suppose that industry X finds itself in a much more competitive product market than it used to face. because they are associated with workers. and paying them severance allowances. Workers in a certain job are trained by the company. when training investments have already been concluded. In the short run (that is.

A firm has no incentives to offer general training at its own expense unless it can somehow tie the trainee to the firm for a period long enough to recoup its investment expenditures. the quasi-fixed nature of the cost implies that their employment will fall more than their average hours of work. the player can become a "free agent" and choose any major league team on which to play. The major effect of immediate free agency would therefore be to destroy the current minor league arrangements for training players. After six years. Very few of their trainees (perhaps 5%) actually make it to the major leagues. For older women. with immediate free agency. The rule under which players are tied to the major league team owning their contract is intended to offer teams a period over which to recoup these general training expenses. Keeping in mind that the major league teams pay the costs of. for whom the costs of employment are unaffected. If players were able to become free agents immediately upon making it to the major leagues. teams would no longer have incentives to scout and train their own players. there will be both scale and substitution effects. but if they do they are bound to the team that owns their contract for a period of six years. the four factors affecting the elasticity of demand for labor can be used to analyze when the substitution effect will be large relative to the scale effect). The major league teams might give up their minor league teams and rely solely on colleges for training professional baseball players. This increased cost. A final alternative might be for the major league baseball teams to collectively operate a minor league system that is financed by assessing each team an equal share of the total costs of running the training operation. The former will tend to reduce demand for their services. Immediate free agency might also cause independent baseball training schools to arise. teams that did not train these players would bid their wages up to a level equal to their marginal productivity. what would be the most important predictable effects of allowing players to become free agents immediately upon entry into the major leagues? Answer: During the training period. 29 . 8. with tuition charged directly to the trainees. will reduce the demand for younger women. and they would tend to adopt a strategy of "raiding" players already trained by other teams. their minor league teams. with wages remaining equal. while the latter will tend to increase it. Teams offering the training would therefore have no way of recouping their investment expenditures. teams are paying the salaries of their minor league players and expending other resources on their training without receiving any revenues in return. Thus. The overall effects of this policy on the demand for older women cannot be predicted from theory alone (however. but derive no revenues from.normal earnings). These costs represent investments in general training. which can only be done by paying a wage less than marginal productivity. Major league baseball teams scout and hire younger players whom they then train in the minor leagues for a period of three to five years.

but rises to $200 in the post-training period. The cost has been “sunk. “Low wage jobs provide fewer hours of work than highwage jobs. An author recently asserted. $24million deal. If the post-training wage is less than $145. 2. or $50x1. Answer. One recent magazine article on economic recovery from a recession argued. Suggested Essay Questions 1. of receiving a return. Answer. Workers in whom the firm has made an investment are paid less then the value of their marginal product. in the hopes.$100 = ($200 .W1)/1. i. Our team is in no position financially to eat the rest of his contract. because firms are slow to hire new labor. and if the training in high wage jobs is firm-specific. A baseball team that has committed itself to a four-year contract has made an investment. so that the firm can recoup investment costs.MP0 < (MP1 .” Analyze the manager’s reasoning using economic theory. of course. “Labor productivity growth usually accelerates in the first year of an expansion. The only thing of relevance is the player’s marginal revenue productivity as compared to the marginal revenue productivity (less marginal cost to the team) of an alternative player. Suppose that a firm is considering training a worker.” so it is of no relevance to any decision about how to use the player during the contract period. if W0 + Z . employers will want to substitute longer hours of work 30 . and this difference offers employment protection when productivity falls in a recession (because investment costs are sunk and the firm will continue to employ a worker in the short run as long as productivity exceeds the wage). What is the most that a profit-maximizing firm can afford to pay the worker in the second period? Answer: The firm will undertake the training if the discounted net benefits from the posttraining period exceed the net expense from the training period. He’s in the third year of a four-year.” Using economic theory. $100 + $50 . so W1 = $145.W1)/(1 + r). I couldn’t get rid of him. 3.e. the firm will make a profit. The worker's MPL is $100 during the training period.Answers to Even-Numbered Problems 2. firms will not hire workers (which involves an investment) until the gap between productivity and wages is again large enough so that the firm can recoup investment costs. The worker's wage is $100 during the training period. Low wage jobs involve less training than high wage jobs. One reason firms are slow to hire in expansions is that they are slow to lay off workers during a recession. is this statement likely to be correct? Why? Answer.1 = $200 . The manager of a major league baseball team argues: “Even if I thought Player X was washed up.” Comment. Plug in the values to solve for W1 at the breakeven point. As productivity rises during expansion.. the cost of training is $50 and the discount rate is 10%.W1.1.

31 . Thus.for hiring more workers. it is consistent with economic theory for employers to require longer hours of work for workers with more skills.

The relationship between the demand for leisure. One is to fix and define more precisely the concepts of income and substitution effects. 2. and income. holding income constant. The incorporation of information on wages and income into the drawing of budget constraints is illustrated. and introduces the concepts of income and substitution effects (they are more rigorously dealt with later in the context of a graphic analysis). 7. the demand for other goods. The five assumptions underlying indifference curves (a graphic depiction of preferences) are discussed. and the supply of labor is the focal point for beginning our analysis of labor supply theory. Our graphic analysis is intended to accomplish two ends. these forces can be graphically depicted. 5.CHAPTER 6 . 8.SUPPLY OF LABOR TO THE ECONOMY: THE DECISION TO WORK Beyond introducing some descriptive material on labor force trends in this century. It then moves to a specific analysis of the demand for leisure time (which in this context is the obverse of the supply of labor). The income effect is the change in hours supplied for a given change in income. Measures of aggregate labor supply generally focus on labor force participation rates and weekly hours of work. wages. 6. The analysis begins with a section that discusses the choice process verbally. building upon what students know concerning product demand. 4. holding the wage constant. Graphical analyses of the income and substitution effects are presented. The major forces affecting labor supply are preferences. trends in these measures are presented and discussed. List of Major Concepts 1. The second is to equip students with a tool necessary to analyze many policy issues affecting work incentives. the primary purpose of Chapter 6 is to present an analysis of an individual's decision concerning whether and for how long to work. The substitution effect is defined as the change in hours supplied attendant on a change in the wage (price of leisure). 32 . A sampling of such policies and their analyses is given in the final section of the chapter (following a section that discusses empirical findings concerning labor supply to the economy). 3. The context of this decision is the traditional labor/leisure choice framework and the chapter is carefully constructed to build the concepts necessary for this analysis.

) The increased wage by itself would tend to induce injured workers to work more because the cost of leisure has risen by 50 cents an hour. (We assume here that the change in workers' compensation payments is not so large as to influence market wages. The way the workers' compensation system works now.5X but those who did work got $0. Suppose the government were to implement a new program in which those who did not work at all got $0. since leisure hours are already at their maximum). this subsidy would be in addition to the wages paid by their employers)." those with zero net wage rates (including those with work requirements). What would be the change in work incentives associated. The concept of "reservation wage" is defined and illustrated graphically. On the other hand. This reduction in income by itself would produce an income effect that tends to induce the injured worker to work more (he or she is poorer if not working than under the previous workers' compensation system). Answers to Even-Numbered Review Questions 2. it reduces the subsidy for people who do not work from $X to $0. Analyses of the budget constraints created by several government income support programs are presented. with this change in the way workers' compensation payments are calculated? Answer: This change in workers' compensation has two effects. however. First. for those who work. Analyzed are those with "skikes. are presented. from both nonexperimental cross-section data and experimental studies.” Answer. 10. The strength of the income effect is relatively weaker when the initial hours of work are smaller.9. 10.5X.5X plus workers' compensation of 50 cents for every hour worked (of course. the substitution effect dominates the income effect. Empirical findings with respect to the labor/leisure choice. 33 . 4. because for labor force participation decisions. employees permanently injured on the job receive a payment of $X each year whether they work or not. the eventual outcome is theoretically unclear. Evaluate the following quote: “Higher take-home wages for any group should increase the labor force participation rate for that group. When initial hours of work are zero – as is the case when a person is out of the labor force – then the income effect is zero if leisure is a normal good (increased resources cannot induce one to increase the consumption of leisure. The effects of these changes can be seen in the figure below. This quotation is correct. the wage rate is increased by 50 cents an hour. and those with positive effective wage rates (as illustrated by an analysis of the Earned Income Tax Credit program).

6. If. the worker faces a clear-cut strengthening of work incentives under the new program. and that the relevant committee was studying two alternatives for increasing work incentives among those disabled enough to qualify for it. The other was to maintain the old benefit 34 . However. Along segment EF the 50-cents-an-hour increase in the wage rate is sufficient to increase the injured worker's income under workers' compensation. however. too. there are income and substitution effects that work in opposite directions. the substitution effect of the increased wage continues to exert an increase in work incentives and the outcome of the two effects is not predictable in advance.Along segment DE there is a clear-cut strengthening of work incentives. To the left of point E. thereby creating an income effect that reduces work incentives. Suppose the Social Security disability insurance (DI) program was structured so that otherwise eligible recipients lost their entire disability benefit if they had any labor market earnings at all. Suppose. the new program would have an unpredictable effect on work incentives. One alternative was to reduce the benefits paid to all DI recipients but make no other changes in the program. other things equal. the worker's tangency point along BC was to the left of point E. Thus. along segment DE there is a substitution effect inducing more work and an income effect that also induces more work. if the tangency point between the worker's indifference curve and the full budget constraint used to be along BC but to the right of point E. however. Thus. Segment DE has a steeper slope than the previous budget constraint (BQ and it also lies to the southwest of BC. that Congress was concerned about the work disincentives inherent in this program. along segment EF.

) Answer: The proposal to reduce the average DI benefit may cause recipients to seek work or it may not. Analyze the 35 . for example. However. it is not clear from theory which proposal would have the stronger work incentives. Others may have preferences that preclude work (case e). some of those who medically qualify for DI but would now work may decide to cut their hours of work (case f). The Tax Reform Act of 1986 was designed to reduce the marginal tax rate (the tax rate on the last dollars earned) while eliminating enough deductions and loopholes so that total revenues collected by the government could remain constant. Compare.levels (for those who receive them) but allow workers to earn $300 a month and still keep their benefits. cases a. The proposal to allow DI recipients to keep their benefits until a certain earnings level is reached will induce some of those now not working to work at least a little (case d). 8. Those who earn over $300 per month would lose all DI benefits. (The use of graphic analyses will be of great help to you. b. depending on their preferences and the extent of the cut. Analyze the work incentive effects of both alternatives. Thus. and c below.

work incentive effects of tax reforms that lower marginal tax rates while keeping total tax revenues constant. Answer: Reducing the marginal tax rate has the effect of increasing the wage rate, because workers are allowed to keep more from any extra hours worked. Keeping tax revenues constant suggests that workers' after-tax incomes also remain constant. Thus, the Tax Reform Act tended to increase the wage while keeping workers' incomes constant -- creating a pure substitution effect that tended to increase hours of work. Answers to Even-Numbered Problems 2. Nina is able to select her weekly work hours. When a new bridge opens up, it cuts one hour off Nina's commute to work. If both leisure and income are normal goods, what is the effect of the shorter commute on Nina’s work time? Answer. When the new bridge opened, Nina’s budget constraint shifted to the right in a parallel fashion as the amount of available time for either work or leisure (as opposed to commuting) was increased. This shift in her constraint created an income effect (she can now work more and consume more leisure). Because both income and leisure are normal goods, both would increase. The only way income can increase in this case is for her to work more, so we must conclude that her extra hour per day from the shorter commute is divided in some way between more work and more leisure. Therefore, she works more. Suggested Essay Questions 1. In 2002, a French law went into effect that cut the standard workweek from 39 to 35 hours (workers got paid for 39 hours even though working 35), while at the same time prohibiting overtime hours from being worked. (Overtime in France is paid at 25% above the normal wage rate.) (a) Draw the old budget constraint, showing the overtime premium after 39 hours of work. (b) Draw the new budget constraint. (c) Analyze which workers in France are better off under the 2002 law. Are any worse off? Explain. Answer. In the drawing below, the old (pre-2002) constraint is ABC, where slope of BC is 25% greater (in absolute value) than the slope of AB. The constraint created by the new law is ADE, where earnings at D are equal to those at B, and the slope of DE is horizontal (workers cannot get paid for more than 35 hours of work).








A 0

 Hours of Work

close to B (that is, they worked close to 39 hours before), will also be better off if their original utility-maximizing indifference curve passed below point D. However, for those whose original utility-maximizing indifference curves passed above point D (almost surely the case for most of those with original tangencies along BC), utility will fall under the new law. 2. Country X cuts the income tax rates applicable to those with the highest incomes, and it newly adopts a wealth tax – a tax that is based on the value of family assets (personal assets, real estate and financial assets) above a certain threshold. Discuss the likely work incentive effects of these tax changes on high-income workers. Answer. The new law changes the constraint from ABC to ADEF.


F Income C




A  Hours of Work

Clearly, the income tax rate reduction increases the slope of the budget constraint (increases the net wage rate). If the wealth tax reduces a person’s overall command over resources (which happens along segment DE), then work incentives are clearly increased – wages are increased while wealth falls. If the effect of the two tax changes serve to increase both the wage rate and the command over resources (compare segment EC with EF), then the tax changes have an ambiguous effect on work incentives, because the substitution and income effects have opposite effects on work incentives.


The household production context of the labor supply decision. Our discussion of the life-cycle aspects of labor supply begins with the observation that household productivity does indeed vary over the life cycle. These insights are discussed after our brief introduction to household production theory in the first section. in this context. The insights provided by the analysis in Chapter 7 are refinements of the basic concepts introduced in Chapter 6. However. In particular. the concepts of household production also lead to a discussion of labor supply over the life cycle. This framework quite naturally leads the discussion of labor supply into the context of families. yields insights about that decision that go beyond those of Chapter 6. AND THE LIFE CYCLE Chapter 7 analyzes the labor supply decision (the decision to work for pay) in the context of household production theory.LABOR SUPPLY: HOUSEHOLD PRODUCTION. The chapter concludes with a policy analysis of "child support assurance" programs. the primary alternative to working for pay is not assumed to be leisure. thereby raising the issue of family labor supply decisions. and leisure in analyzing why the substitution effects for women might be expected to be larger than those for men. Further. and to sacrifice Chapter 7 would mean forgoing concepts and empirical work close to the frontiers of economic analysis. The "additional worker" and "discouraged worker" hypotheses are also discussed in this context. Instructors facing severe time constraints may wish to skip this chapter. The graphic analysis of household production and the choice of household production technology is shown to be completely analogous to the graphic analysis and fundamental implications of the labor/leisure choice discussed in Chapter 6. of course. however. Chapter 7 summarizes some recent directions in which labor supply theory has been going. We discuss such family labor supply decisions as who stays home to care for children (if anyone does). causing intertemporal substitution effects. do wages).CHAPTER 7 . since one's household productivity varies considerably across the life cycle (as. but household production. The chapter begins with an introduction to the concept that households combine time and goods to produce commodities that are consumed at home. 39 . Labor supply over the life cycle is also affected by the way wages typically vary with age. household work. In this chapter. The traditional interrupted careers of married women cannot be explained without reference to the shifts in household productivity that take place when children are born and as they grow older. and they do not contradict the insights or predictions of Chapter 6. and the interdependency of the spouses' labor supply decisions. THE FAMILY. we discuss the important issue of choice of retirement age (including data on the way lifetime Social Security benefits vary with age of retirement). we point out the tripartite choice between market work. whether both spouses will work for pay.

for those who worked for pay in the absence of such programs. not on income. However. 5. leisure). 4." 6. 40 . which tend to create budget constraints with zero net wage rates. however. Labor supply decisions over the life cycle are affected by household productivity changes and predictable changes in wages over the life cycle that create intertemporal substitution effects without corresponding income effects. 8. there will be changes in the time intensity of commodities consumed as well as in the time intensity of household production technologies. should remain home instead of working for pay) have yet to be completely modeled. In contrast with welfare programs. if either. 3. The principal predictions associated with the income and substitution effects in the labor/leisure model are unchanged in the context of the household production model. Household commodities may be produced by time-intensive methods or by goodsintensive methods. emphasizing how delaying retirement by a year can affect the present value of one's total income over the remaining years of expected life. household work. Child support assurance programs ensure transfer payments to custodial parents based on the age and number of children. child support assurance programs preserve incentives to engage in market work. Joint household production decisions (which spouse.List of Major Concepts 1. Graphic analysis of the choice of optimum retirement age is presented. The latter model. As wages change. 9. 7. The "discouraged worker hypothesis" and the "additional worker hypothesis" are discussed in the context of household production theory. the pure income effect created by support assurance programs should tend to induce fewer hours of paid work. but they must clearly take account of the partners' marginal productivities at home and the wages they can command in the "market. the method chosen is in part a function of the price placed on time. The basic concepts of household production theory include the combining of goods and time to produce commodities that yield the family utility. adds a third dimension of choice about time usage (market work. 2.

and if she already works.Answers to Even-Numbered Review Questions 2. serve to increase productivity in paid employment (that is. the wife may also decide to work more if they are complements in household production (or consumption). All these factors tended to raise market productivity relative to household productivity. but if she gets a raise. Increased urbanization also tended to make it easier to substitute goods for household production. a wage increase will increase her chances of labor force participation. if a married woman's husband gets a raise. declining fertility rates. that raise (to her) has an income effect. they must make their labor supply decisions jointly. the increased education of women. Primary among these was the rise of the clerical and professional sectors. theory cannot predict which one is dominant. 4. The text pointed out. Is the following statement true. both of these factors flatten the household utility isoquants (an hour of household productivity forgone can be replaced more readily by goods purchased with money). Relate each of these factors to the household production model of labor supply that was outlined in Chapter 7. 41 . if her wage rate rises. However. while the invention of labor saving devices in household production make it easier to substitute goods purchased with cash for time at home. and some of them served to increase the strength of the substitution effect relative to the income effect. the answer to this question really depends upon whether one assumes the two spouses have household productivities that are interdependent. if the husband's wage increase caused him to work more. she tends to work less. false. she tends to work more. if so. labor saving advances in households. This increased income without a corresponding increase in her wage rate tends to induce her to work fewer hours. to increase the wage rate that women can command). and increased urbanization." Answer: Ignoring the question of joint labor supply decisions. Thus. that spouses may make their labor supply decisions jointly. or uncertain? Explain. "If a married woman's husband gets a raise. she will experience both an income and a substitution effect. as well as increased educational levels. For example. though. If she is out of the labor force. Declining fertility rates tend to reduce the productivity of hours spent at home. Answer: One of the central aspects of the household production model of labor supply is the importance of the relative productivity in paid employment as compared to household production. Increased opportunities in the clerical and professional sectors. A recent study of the labor force participation rates of women in the post-World War II period notes: Over the long run women have joined the paid labor force because of a series of changes affecting the nature of work.

where at a given time individuals have an expected lifetime wealth and also face predictable changes in their wage rate as they age.2. 8. Other recent studies point out that hourly wages tend to rise over the early stages of the life cycle (the young receive lower wages than the middle-aged) and that young males tend to work fewer hours than middle-aged males. For a discussion of how these services can be valued. If the old budget constraint is AB below. she would be determined to qualify for half of the assets at the date of divorce. if the wife earned an income equal to her husband's throughout the years. other things equal. Discuss the likely effects on labor force participation and hours of work. the new one will have a steeper slope (reflecting a net wage that is $3 per hour higher) for the first 8 hours of work (see AC). 42 . Suppose that. the financial settlement in a divorce case that does not involve dependent children depends upon the economic contribution each marriage partner made up to the date of divorce. explain the apparent discrepancy. Thus. Draw a current budget constraint for an assumed single mother (net of child care costs). Employing a theory of life-cycle allocation of time. Several studies have indicated that for prime-age males. Suggested Essay Questions 1. holding constant the individual's expected lifetime wealth. and then draw in the new constraint. studies of the life-cycle effects of lower wages in the early stages of one's working career with higher wages later on are examining these wagechange effects over an individual's lifetime. up to 8 hours per day. Answer. and suppose the government adopts a child-care subsidy that pays $3 per hour for each hour the parent works. The latter studies are in the pure life-cycle mode of analysis. under state law. However. raised the family's children. but that it now want to adopt a plan that will encourage labor force participation among single parents. Based on what you have learned in Chapter 7. In both cases there are both substitution effects and income effects of wage changes. the income effect of a wage increase tends to dominate the substitution effect.6. and never worked for pay? Answer : A wife who did not work for pay nevertheless contributed to the family's income by performing household production services that would otherwise have had to be purchased in the market at some cost. Assume that a state government currently provides no child care subsidies to working single parents. how could an equitable settlement be determined in the case of a woman who stayed home. Answer: Studies showing that for prime-aged males the income effect of a wage increase tends to dominate the substitution effect look either at wage increases that have occurred as society has become wealthier and more productive or at wage rates across individuals in a population. a woman who performs household services saves the family money that it would otherwise have had to spend. Put differently. see Example 7. Suppose that child care costs are hourly. With these studies there is a substitution effect – leading to more work as wages rise – but no corresponding income or wealth effects.

Thus.after that. the pre-subsidy constraint is AB. some people working over 8 hours a day before may reduce their supply of hours and move to point C on the constraint. Assume that a state government currently provides no child care subsidies to working single parents. Suppose child care costs are hourly. some workers who were out of the labor force before will now join. and that the government adopts a child-care subsidy of $20 per day if the single parent works 6 or more hours per day. and then draw in the new constraint. Those single parents who were out of the labor force before (maximized utility at A) and who have very steep indifference curves will tend to remain at point A. and those who do will 43 . Thus. those with flatter indifference curves will find that their utility is maximized at point D. but that it now want to adopt a plan that will encourage labor force participation among single parents. the higher wage rate will tend to increase labor force participation (the substitution effect dominates for participation decisions). so the net effect is not predictable. The subsidy of $20 per day (CD) begins at 6 hours of work and continues for all levels of work hours beyond 6 (segment DE. However. the income effect and substitution effects of this wage increase will have opposite tendencies on the hours of work. however. Income B D C A 8  Hours of Work 2. the new constraint is ACDE. Discuss the likely effects on labor force participation and hours of work. Draw the current budget constraint (net of the hourly child care costs) for an assumed single mother. which is parallel to AB). the budget constraint is segment DB. Answer. In the drawing below. Among those single parents not working before the subsidy is adopted. For those already working (tangencies along AC).

desire jobs offering exactly 6 hours of work per day. the income effect of this subsidy will create a tendency for them to desire fewer hours of work (as long as the hours do not fall below 6). Income E B D C A 6 Hours of Work 44 . For those working more than 6 hours per week before. the tendency also will be to move to 6 hours of work (although it is possible that some will have such a steep indifference curve to the left of their tangency along segment AC that they will not be better off by working 6 hours). For those along AC before (working less than 6 hours per day).

This appendix offers another application of the theory of compensating wage differentials to an interesting policy problem.CHAPTER 8 .COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS Chapter 8 introduces students to the concept of compensating wage differentials. The application in this section of the chapter relates to the regulation of employee benefits. worker behavior will generate compensating wage differentials for job characteristics that are unpleasant or costly. Employee preferences are graphically expressed in the concavity and slope of indifference curves. worker information. The analysis also introduces the student to the notions of "risk aversion" and the willingness to pay for insurance ("certainty"). 5. Following the practice in earlier chapters. 45 . 3. Once the essential assumptions and predictions of economic theory in this context are explained. Again. particularly pensions. Employers with different costs of eliminating unpleasant job characteristics can be graphically represented. the analysis begins with a verbal exposition of occupational choice and the wage outcomes that flow from this choice when jobs differ along nonpecuniary dimensions. and in so doing elucidates certain issues not commonly understood. Policy implications are related to occupational safety and health legislation. For those who wish to enrich the coverage in Chapter 8. we introduce students to a graphic analysis that is intended to yield additional insights. The prediction that there will exist compensating wage differentials for unpleasant work rests on assumptions of utility maximization. We first apply the concepts of hedonic theory to a "bad" job injuries. List of Major Concepts 1. Compensating differentials play a dual role in allocating labor to unpleasant jobs and in compensating those who accept unpleasant work. and worker mobility. The graphic analysis of the issue of occupational choice is also intended to provide students with a tool for analyzing the effects of government policies on the labor market. we have added an appendix that analyzes worker choice of jobs that have different probabilities of layoff. A market equilibrium curve (or offer curve) is derived from the zero-profit isoprofit curves of the employers in the market. In the context of full information and choice. 2. it seeks to move students from concepts they are familiar with to new concepts and tools. 4. We then apply the theory to an analysis of how elements in the employment "package" on which employees place a positive value affect the wage rate. 6.

dangerous work. 10. their behavior will force even the most greedy executives to pay higher wages for filthy. caring only for themselves. Government attempts to regulate the outcome of labor market decisions that are made in a perfectly functioning market could lead to a reduction of utility for the workers the government is intending to help. and the degree to which layoffs cause the worker's income each year to fluctuate. if not all costs or benefits of the decision are borne by those making them). 9. If workers are informed about job hazards and have a choice about the jobs they take. and to do so must pay a wage that workers will accept. Both statements can be simultaneously true. (Appendix) The concept of risk aversion is related to the hypothesis that the expected utility of a level of income ($X) received with certainty is greater than the expected utility of a stream of income that may fluctuate over time but yield an expected yearly value of $X. 12. 13. 14. Government intervention into the labor market can increase worker utility if the market is not functioning perfectly (that is. Answers to Even-Numbered Review Questions 2. (Appendix) There are two issues relating to the undesirable characteristics of layoffs: the degree to which yearly layoffs (known in advance) constrain a worker's hours of work to lie below those otherwise desired. Statement 1: "Business executives are greedy profit maximizers. employees who are least averse to an unpleasant job characteristic become employed with firms that find it most expensive to eliminate that characteristic. Even the greediest profit maximizer must obtain a work force." Can both of these statements be generally true? Why? Answer. The theory of compensating differentials can only be tested using techniques that control for other influences on job characteristics. dangerous work receive higher wages. If the market is working properly. they will accept those offers and turn down work at the more dangerous or filthy workplaces. The mix of wages and benefits in the compensation package depends on both employee preferences and the trade-offs employers are willing to make. If workers have alternative job offers that pay the same wage but offer better working conditions. 46 . other things equal. 8. Their behavior then will force owners to either pay the compensating wage differentials or clean up the workplace. (Appendix) Some job characteristics normally considered bad may be considered good by some workers (layoffs may be preferred if they are known in advance). 11." Statement 2: "It has been established that workers doing filthy.7.

or cannot. those previously offering less must have been compensating their workers in some other way (to make their jobs as attractive as those of their competitors). Thus. We would expect wages for highway workers in the city to be high relative to the market wage. Under-the-table payments provide a supplement to the Supervisor's regular salary. Use economic theory. Answer. must be at least equal to the prevailing wage. This means that the wages they receive. If the market is not allowing workers to “buy” (in the form of lower wages) the life insurance they want. Alternatively. It is thus likely that low-insurance employers were paying higher wages than those offering more insurance. by analogy. can be low relative to the market. mandating that employers offer at least $50. From the perspective of positive economics. Would you expect wages paid to highway workers by this city to be higher or lower than the market wage? Would you expect the salary paid by the city to its Supervisor of Highways to be above or below market? Explain. Answer. 47 . To now compete with their competitors in the product market. so that even if the Supervisor's salary is low the job may attract a satisfactory flow of applicants.4. If the labor market is perfectly functioning. workers are able to obtain the combination of wages and life insurance that maximizes their utility. then mandating increased insurance could improve the welfare of affected workers (as long as the mandate does not require workers to buy more than they are willing to pay for). Suppose that Congress were to mandate that all employers had to offer their employees a life insurance policy worth at least $50. it is an indication that the wages paid by the city are relatively high. In order for workers to be attracted to highway jobs in the city they must take home wages that are at least as great as they could obtain elsewhere.000 in life insurance will obviously have no effect on those who are already offering that much or more. If the Supervisor is able to extract under-the-table payments from these workers. both positively and normatively. 6. but it will add to the costs of those who were previously offering less. the wages in firms previously offering less insurance will decline. then employment among these employers will fall. To be competitive in the labor market. From the perspective of normative economics. decline by enough to fully offset the added costs of more insurance. Suppose highway workers in a certain city are required to give the Supervisor of Highways an under-the-table payment of $X per year. Of course. the affected employers must reduce their wages (to keep overall costs in the competitive range).000 in the event of death. we would like to know if this mandate improves the welfare of the workers affected. to analyze the effects of this mandate on employee well-being. The Supervisor's wage. less any bribes they must pay. one can look upon the bribe as an undesirable element of employment for which the workers would have to receive a compensating wage differential. then their utility will decline. if wages do not. If the mandate forces them to take some other mix.

) Answer. compensating differentials cannot exist. They both advertise for help and. Thus. workers dislike the smell of perfume. The level of smell in California is S*. with very few applicants. "The concept of compensating wage premiums for dangerous work does not apply to industries like the coal industry. and this is tantamount to the receipt of a compensating wage differential. when working conditions differ. the safe mines receive many more applications than the dangerous mines. But a natural corollary of this is that. Because all mines must pay the same wage. Draw a diagram using isocost and indifference curves that depicts the situation. Both sets of mines must pay the same wage rate and offer the same fringe benefits.) Suppose that there is no cost for firms to reduce or eliminate the smell of perfume in perfume factories and assume that the workers have an alternative wage. and they will tend to hire the most dependable. while in California workers appreciate the smell of perfume. Consider the conditions of work in perfume factories. where the union has forced all wages and other compensation items to be the same. (The New York and California isocost curves are the same. Answers to Even-Numbered Problems 2." Is this statement correct? (Assume wages and other forms of pay must be equal for dangerous and non-dangerous work and consider the implications for individual labor supply behavior. This statement is not correct. Put differently. but their indifference curves differ. highly productive workers getting wage $X. most motivated employees. assuming workers quickly find out which mines are safe and which are dangerous. in New York it is 0. This wage equals W*. W*.8. In New York perfume factories. people of different skills might receive the same wage.) What level of perfume smell is there in the New York factories? In the California factories? Is there a wage differential between the California and New York workers? Answer: See the figure below. The safe mines can thus be highly selective about the applicants they choose. To understand how the market would adjust. will have to take who they can get (those workers not chosen to work in the safe mines). 48 . let us assume that we have a set of relatively safe coal mines and a set of relatively dangerous coal mines. workers of unequal productivity would receive the same wage. provided that the level does not climb above S*. while the dangerous mines will have lower quality workers obtaining the same wage. The dangerous mines. In both cases workers in less desirable circumstances receive higher wages than they would otherwise receive. they start to dislike it. the theory of compensating wage differentials says that people of equal skill will receive different wages when working conditions differ. hardest working. (If it rises above S*. The California workers are paid exactly the same as the New York workers. Safe mines will have high quality.

This law does not apply to smaller firms in the country. If they value the ability to work overtime. employment shrinks and wages rise in the small-firm sector. However. how do you think this law might affect wages and employment in the two sectors? Answer. then more would seek work in that sector. A country passes a law. The immediate effect on workers in large firms is to give them a wage increase of around 10% (work 35. The higher wages in the latter sector would reflect a compensating differential for the restricted access to a valuable workplace characteristic.Suggested Essay Questions 1. while at the same time prohibiting overtime hours from being worked. some in the large-firm sector may seek jobs in the small-firm sector (where it is still possible to earn a 50% premium for hours in excess of 39) – which would drive down wages in the small-firm sector and drive them higher in the large-firm sector. (Overtime had been widespread in both sectors. while employment grows and wages fall in the large-firm sector. are paid for 39). and is paid at 50% above the normal wage rate. applying only to large firms. In this latter case. but the law also prevents them from working overtime. How wages and employment respond depends on the value workers put on overtime work. if workers now see jobs in the large-firm sector as more desirable than before (given the immediate wage increase and the inability of employers to demand overtime work of their employees).) Using economic theory. that cuts the standard workweek from 39 to 35 hours (workers are paid for 39 hours even though working 35). 49 .

do these facts contradict the theory of compensating wage differentials? Answer.” Assuming this statement if true. jobs with low non-wage benefits would have to pay higher wages.2. other things equal. 50 . and the flexibility in their work lives that most American workers take for granted. The theory of compensating differentials predicts that. A recent article stated. where clearly “other things” are not comparable. the health benefits. This statement is implicitly comparing those in low-skilled jobs with those in high-skilled jobs. “Workers in low-wage jobs lack the basic security. Thus. the facts in this statement do not contradict the theory of compensating wage differentials.

we consider the question of whether education is a good investment. Next. we devote a section to evaluations of government job training programs. Because investment returns flow in over several years. 5.INVESTMENTS IN HUMAN CAPITAL: EDUCATION AND TRAINING Chapter 9 introduces students to the concept of human capital and treats in detail education and training investments. We introduce age/earnings profiles and discuss the reasons for their convexity. Appendix 9B presents a hedonic model of education and wages that uses the graphic tools of Chapter 8. The chapter begins with a section on the demand for education by workers. an analytical tool to convert future sums to present value is required (the concept of present value and discounting future sums is explained in some detail).CHAPTER 9 . Implications of this model for both individual and aggregate (market) behavior are then derived. in which a theory of human capital investment is formulated and a formal model of choice is presented. 2. in which the need for educational investments slows down the supply response to changes in market demand. Investments entail costs in the current term with returns flowing in over later periods. This hedonic model is useful in explaining several empirical facts about the relationship between education and wages. and the discussion also serves to integrate the concepts in Chapters 8 and 9. 3. 4. Costs of human capital investments include out-of-pocket expenses. The second section of the chapter analyzes the relationship between education and earnings. and we discuss possible biases (including selection biases) inherent in these findings. The major findings of the literature with respect to the individual rates of return to education are summarized. forgone earnings. When discussing education as a social investment. we introduce both the traditional answers of the "human capitalists" and the more agnostic views of those who see education as purely a signaling device. Investments in human beings are part of the general category of investments. List of Major Concepts 1. by people who are young. and psychic losses. Human capital investments are more likely to be made by people who are not present oriented. Appendix 9A presents and explains a "cobweb" model of labor market adjustment. We analyze this question from both an individual and a social perspective. Included in this section is an analysis of the differential convexity among such profiles for men and women. In this context of evaluating education and training as investments. in situations in which the costs of human capital 51 .

Some differences between men and women in the acquisition of education and training (including university majors) can be explained by lower rates of return to some human capital investments among "traditional" women. Post-schooling investments in on-the-job training can help account for both the convexity and the fanning out of age/earnings profiles. 9. affecting college enrollments in predictable ways. jobs that require more education or training must pay a higher wage to attract workers (that is. 8. 16. one's actual earnings approach potential. Post-schooling investments reduce actual earnings below potential earnings. 52 . then firms can use educational attainment as a screening device (workers will sort themselves out according to ability in choosing their level of educational attainment). 15. and as such investments decline over age. and in situations in which the returns to these investments are larger. Evaluations of whether education is a good social investment must consider the hypothesis that education acts as a screening device. who expect interrupted labor market careers. Evaluations of whether education is a good individual investment typically present rate of return estimates that involve three sets of biases: upward biases associated with the correlation between education and ability. and the present value of these gains typically exceed program costs. Variations in the returns to human capital investments call forth supply responses by individuals. rather than an activity that enhances productivity. 12. 10. Age/earnings profiles are flatter for less educated workers. Because education is costly. and selectivity biases arising from the fact that people who choose one career may be more productive in that career than a comparably trained person who does not choose that career. 11. reflecting smaller human capital investment costs in their early years and lower growth of productivity. to compensate them for the cost of investment). If the full cost of education is inversely related to are lower. 14. 13. and if ability is positively related to on-the-job productivity. 7. (Appendix 9A) Delays in supply responses associated with the long gestation periods of some human capital investments can create periods of oversupply followed by periods of shortage (the "cobweb model" as it applies to the labor market). downward biases associated with the failure of monetary earnings to reflect all the benefits of a college education. Public sector job training programs have created demonstrable earnings gains only for adult women. 6.

older workers are less likely to have decided to invest in retraining – with the result that only the younger workers became qualified to apply to Employer Y. full-time retraining program offered by a local agency.17. What are the likely labor market effects 53 . Y’s claim is consistent with human capital theory in two respects. First. That is. From what you know of human capital theory. its own hiring and training costs appear to be negligible (we are told that it offers no training on its own. and a shorter period over which benefits are received reduces these benefits. Second. promulgates legislation requiring all new mechanics to take three years of post-high school training and to pass a competency test. All workers have to decide whether a human capital investment opportunity will have expected benefits (properly discounted to the present) that are at least equal to the costs. potentially beneficial human capital transactions may be discouraged. Suppose that the government. because the retraining program to which X’s former employees had access was “lengthy. does Y’s claim sound credible? Explain. the optimum allocation of resources requires that all mutually beneficial transactions be accomplished. and if these higher wages cannot be paid. and that its hiring standards consist of taking successful graduates of another program). because the acquisition of training and education is costly. human capital investments that might have been made will be discouraged. human capital investments will not be undertaken unless there is a future return to them. Answer: As indicated in Chapter 1 and elsewhere." Comment. it therefore has no reason to prefer younger workers. Employer Y (which offers no training to its workers) hired many of X’s employees after they had completed a lengthy. During this investigation employer Y claimed that it hired all of the applicants from X who had successfully completed the retraining program. Thus.” it may well be that only the younger workers from X decided to invest in this retraining. without regard to age. (Appendix 9B) The hedonic model implies that those who obtain the most education are least averse to learning and probably most able to learn quickly. If wages are forced toward equality by government fiat. 4. the pursuit of wage equalization across skill levels will discourage human capital investment and may result in too few workers entering skilled occupations. When Plant X closed. 6. The city’s Equal Opportunity Commission noticed that the workers Employer Y hired from X were all young. Thus. Because it makes no major investments in its workers. Those who are currently mechanics will not be subjected to these requirements. and it launched an age-discrimination investigation. Answers to Even-Numbered Review Quesitons 2. "The vigorous pursuit by a society of tax policies that tend to equalize wages across skill groups will frustrate the goal of optimum resource allocation. in an effort to upgrade the quality of mechanics. These returns normally are in the form of higher wages paid to those with the higher skill levels. Answer.

because with an investment costs are borne in the present and the returns come later. Reducing the benefits could be accomplished by installing protective devices that make burglaries less likely to succeed. low quality repairs to doing the work themselves. If imprisoned.of this legislation? Which labor and consumer groups would gain and which would lose? Answer: The overall effect of this requirement to license mechanics will be to reduce the supply of mechanics and to increase their wages (average quality will rise as well. the gainers will be those who want high quality repairs and previously had to spend time and effort to distinguish the high quality from low quality mechanics. Losers will be poorer consumers. lower cost mechanics in the future). Characteristics that tend to reduce the expected costs of committing a crime are a high discount rate (a "present orientation") and relatively poor earnings prospects in the labor market (less to lose by being jailed). The labor market groups that lose include those who would have become low cost. or to having no repairs at all. What can society do to reduce crime? Answer. but mandating such training will prevent some from entering the profession and force others to undertake such training even though it might be very costly for them in economic or psychic terms. Using the framework for occupational choice in the long run. to paying the higher cost for high quality repairs. 8. Many crimes against property (burglary. low quality mechanics. To reduce crime society needs to reduce the immediate benefits or increase the expected future costs of committing a crime. increasing the length of incarceration. these potential mechanics will either be barred from the market or will have to make training investments that they would not otherwise have made. Increasing the costs can be done by increasing the likelihood of catching thieves. analyze what kinds of people are most likely to engage in criminal activities. Put differently. the criminal loses income from both criminal and noncriminal activities. and future mechanics of high quality (who will not have to compete with low quality. or raising the labor-market earnings potential of those currently with the least to lose. Answers to Even-Numbered Problems 54 .) The labor market groups that gain are current mechanics. who may have preferred low cost. for example) can be thought of as acts that have immediate gains but run the risk of long-run costs. Committing a crime like burglary is essentially the mirror image of a human capital investment. Among consumers. whose wages will be increased but who are not subject to the licensing procedure themselves. the returns to training for those who would have obtained it anyway will rise.

W.) b. Find the equilibrium wage and employment levels.) 55 . while the demand curve is given by Ld = 50 . the short-run supply of optometrists is fixed. Draw a graph to show these events.6W. Calculate the wage and employment levels in each of the first three rounds and find the new long-run equilibrium.W. (Appendix) Suppose the supply curve for optometrists is given by Ls = -6 + . a.W and solving for W. b.6W = Ld = 50 . Now suppose that the demand for optometrists increases and the new demand curve is L'd = 66 .2. While this adjustment is taking place. First round: L is still 15. Answer: a. Assume that this market is subject to cobwebs because it takes about three years to produce people who specialize in optometry. where W = annual earnings in thousands of dollars per year and L = thousands of optometrists. Initial equilibrium W = $35. (Find this by setting Ls = -6 + . W = 15. This is point A in the figure. so W = $51. (Find W by plugging L = 15 into the new Ld equation.

so dropping out may not send the same signal of low aptitude or tolerance. however. for American high school dropouts. Analyze how opening new schools will affect child labor. and then plugging L = 24. lowers the cost of investing in human capital – and theory predicts that more young students would attend school rather than work. 56 . (Find this by setting Ls = -6 + .6W = Ld = 66 . even if they later obtain a GED. ages 10-14. Find this by plugging W = $41.) Suggested Essay Questions 1. A study shows that. Can signaling theory be used to explain these results? Answer. these immigrants are certified as knowing the equivalent of American high school graduates. Assume that a developing country with a labor force that includes many children.4 (at point C). Graduating from high school is more or less the expectation for American students. 2.84. L = 21. though a GED.4 into the Ls equation to find L = 18. but this pushes W down to $41. obtaining a GED has a relatively large payoff. Suppose that it decides to open more schools.84 into the new Ld equation. wants to reduce the use of child labor. If. so that children who do not now have a school near their home can attend a school without a long commute. perhaps involving living away from home) to school. Making schools more geographically accessible. which will be nonzero for children who could work. A second element. It also shows. and those who drop out may be viewed as having a low aptitude (or low tolerance) for learning. Answer. that for immigrants who did not complete high school in their native countries. One element of cost is forgone earnings. obtaining a General Equivalency Degree (GED) by part-time study after high school has very little payoff. but this pushes W up to $47. L = 24. employers may prefer them to American GED recipients.6 into the new Ld equation. is the cost of commuting (time and expense. Long-run equilibrium. Human capital theory suggests that those making decisions about investing in schooling weigh the present value of expected future benefits against the near-term cost. explaining these effects fully.16 (see point E). Immigrants may come from countries in which high schools are either more demanding or less available. W = $45.6.84 and then plugging L = 18.Second round: Labor supply reacts to first round wage.W and solving for W. other things equal. however. Find this by plugging W = $51 into the Ls equation to find L = 24.6. L = 18. then. Third round: Labor supply reacts to second round W.

AND TURNOVER This chapter employs the human capital framework to analyze the phenomena of geographic mobility and worker turnover. 5. There is an element of self-selection in immigration because those who are most likely to migrate are those for whom the net benefits of migration are largest (although the benefits are often initially depressed by unfamiliarity with the language or customs of the area to which they have moved). costs of finding out about alternatives elsewhere. IMMIGRATION. However. It considers the problem of illegal immigration and uses economic theory to identify the gainers and losers from a more restrictive immigration policy. instructors who want their students exposed to human capital analysis as it applies to geographical mobility and turnover.S. 3. including the personal characteristics of those most likely to exhibit either kind of mobility. List of Major Concepts 1. in which the benefit is added utility in the future and the costs are the direct and psychic costs of quitting one employer and seeking work elsewhere. The chapter also describes and analyzes immigration policy in the United States. the section does not directly employ human capital analytics. immigration has tended to become less-skilled in recent years. People will move from jobs or areas where pay is relatively low to jobs or areas where pay is relatively high unless such mobility is inhibited by a short time horizon (or high discount rate). 2. migration investments can fail to work out as expected. Like other investments." 57 .WORKER MOBILITY: MIGRATION. of course. while those with distributions that exhibit greater variance will tend to send less-skilled workers to the United States. Worker mobility can be viewed as a human capital investment. the section on immigration concludes with an analysis of the overall effects of immigration (including illegal immigration) on the "native" population. resulting in "return migration.CHAPTER 10 . The lengthy section on U. 4. Countries in which the earnings distributions is more compressed than in the United States will tend to send relatively skilled workers to the United States. It demonstrates how the insights of human capital theory can explain the observed patterns of mobility and turnover. Thus. motivated by our human capital analysis of individual migration. or high costs of the move itself.S. U. and who are willing to forgo an analysis of the very topical issue of illegal immigration and what to do about it. Finally. immigration policy is. could save some time in the course by eliminating the section of the chapter on immigration policy.

6. If there are high costs of migration. 11. However. 12. "Matches" between employer and employee are improved through the process of voluntary quits and involuntary layoffs. The costs of quitting and searching for a new job may produce an upward sloping supply curve to individual firms. The argument that immigrants fill jobs no "native" would take overlooks the fact that inducements to work in a particular occupation are not independent of the wage being offered. 10. One way for the government to facilitate economic growth is for it to pay workers in depressed areas to move to regions where jobs are more plentiful. This move will shift the supply curve for 58 . Answers to Even-Numbered Review Questions 2. The effects on employment in areas of reduced economic opportunity and the effects on wages in both areas depend on assumptions made about the labor market. interregional migration would be increased as a response to this migration subsidy. and employment would grow in areas of high economic opportunity. If immigrants receive wages equal to their marginal product. leading to monopsonistic behavior. then there would be incentives for workers to leave the low wage area and migrate to the higher wage area. the pattern of quit rates across age groups. Clearly. 8." 7. What would be the labor market effects of such a policy? Answer. The human capital model can be used to model quit behavior. but only in special circumstances would an influx of X immigrants take X jobs away from "natives. and international differences in quit rates. more people will respond to a given wage differential and move from the depressed area to the area of better opportunity. Human capital theory can shed light on the cyclical pattern of quit rates. 9. Immigration may increase product demand and the demand for other skill grades of labor. when the costs of migration are reduced by the subsidy. If it is assumed that the labor markets in both areas are in equilibrium and that wages in the area of reduced economic opportunities are lower than they are elsewhere. A large influx of immigrants will tend to lower wages in the relevant labor markets and create more employment. the native population as a whole will not experience a loss of income unless the immigrants receive government services whose value exceeds the taxes they pay. some workers would not respond to a moderately large wage differential because the increase in wages would not be sufficient to cover the cost of migration.

6. the decline in demand brought about by the reduction in product demand would be mitigated or even offset by the increased substitution of skilled workers for the now-moreexpensive unskilled labor.) Workers from outside the United States who would otherwise have become illegal immigrants (but who are now deterred from immigration) will be worse off. How would a decline in the wage gap between the skilled and the unskilled affect immigration to the United States? Answer. The reduced net benefits from migration should reduce the number of illegal immigrants coming into the country and. However. those who decide to immigrate and are not apprehended will be better off because they will receive higher wages in the unskilled market. this reduction should raise wages in the unskilled labor market. Suppose that workers eventually adjust to this gap by investing more in education. Immigrants at least implicitly compare the wages they can expect in the United States with those they can expect in their place of origin. Skilled workers may be adversely affected by this new policy because reduced immigration may mean reduced product demand (and therefore have a scale effect on the demand for their services). the reduction of unskilled employment and the increase in the unskilled wage may cause the demand for skilled workers to decline. with the result that the wages of less-skilled workers rise faster than those of the more-skilled (so that the wage gap between the two falls). Analyze the effects of this increased penalty on the wages and employment levels of all affected groups of workers. if skilled and unskilled workers are gross substitutes. there will be a reduction in wages and employment in the skilled markets. Moreover.the depressed area to the left. If there is a leftward shift in the demand for skilled workers. Suppose the United States increases the penalties for illegal immigration to include long jail sentences for illegal workers. Thus. The last two decades in the United States have been characterized by a very wide gap between the wages of those with more education and those with less. Employment in the unskilled market goes down. if the American unskilled 59 . although it may not affect the wage rate. although unskilled employment among natives increases. shift the supply curve for the area of better opportunities to the right. Thus. If the problem in the sending area is one of unemployment due to wage inflexibility in that area (that is. Answer. then an increase in outmigration will reduce unemployment in the sending area. unskilled native workers benefit by the imposition of jail sentences on illegal immigrants who are apprehended. and thus reduce the wage differential between the two areas. assuming these immigrants are unskilled workers. the wage rate lies above the equilibrium wage). even if the probability of being apprehended is small. if skilled and unskilled workers are gross complements. Jail sentences for illegal immigrants would reduce the net gains from immigration. (Of course. 4.

5 = $125 per hour. When the American earnings distribution becomes more equal. See the figure. This will increase from area W1AB in the figure to area W2AC. Further. by how much will the short run profits of employers in this market change? Answer: The short-run profits of the employer equal the area below the MPRL curve and above the wage rate. Find the wage rates by plugging the employment levels into the Ld equation. Suppose that the demand for "rough laborers" is Ld = 100 – 10W. and more incentives for unskilled immigration from countries with less-equal distributions. profits have risen by $55 per hour. 60 = 100 – 10W after the immigration. so W = $4 per hour. the United States should experience a rise in unskilled relative to skilled immigration. there will be reduced incentives for skilled immigration from Europe. so the area of W1AB is 50x$5x. so W = $5 per hour. Skilled workers tend to come from countries with more equal earnings distributions than found in the United States (many European countries. Thus. and the area of W2AC is 60x$6x.5 = $180 per hour. 60 . 50 = 100 – 10W initially.5(base x height). for example). If immigration increases the number of rough laborers hired from 50 to 60. The area of the triangle is . say. Answers to Even-Numbered Problems 2.wage rises relative to the skilled wage. because this declining gap between the educated and the less-educated serves to make the American distribution of earnings more equal. where W = wage in dollars per hour and L = number of workers. while unskilled workers tend to come from countries (often developing countries) with less equal earnings distributions.

will tend to increase turnover at the firm. 2. The provision of these non-wage benefits is costly.” The company is unusual in that it offers air conditioning. and so forth – and because these amenities are unusual. Would you expect the wages these two countries pay for otherwise-comparable male immigrants to be roughly equal? Why or why not? Explain. A particular manufacturing company employs low-skilled workers in a developing country in which turnover among such workers is generally high. partly because female immigrants who want to work will not go there and partly because married men will avoid A because of the restrictions on their wives. and the theory of compensating differentials suggests that their presence will serve to reduce the wages that their workers could otherwise command elsewhere. those who place a high value on them will tend to remain with the firm (the could not get them elsewhere). who perform menial jobs that local workers are unwilling to perform. Lower wages. The supply of immigrants to A will be restricted. and monthly parties. Country B has no such restrictions. air conditioning. drive or go out of the house without a chaperone. Two oil-rich middle-east countries compete with each other for the services of immigrants from India and Pakistan. Answer. The wages in A will have to be higher in order to attract immigrants. education in English. especially among workers who do not value the nonwage benefits very highly. In what ways might these policies make it difficult to retain employees. The company’s president states that it is her goal to ensure that “workers have a serious emotional connection to our company. showers. However. by themselves. these benefits will also serve to attract those who value the amenities of parties. 61 .Suggested Essay Questions 1. Country A does not allow women to work. and in what ways might they help? Answer. tuition for English courses.

Dividing a "surplus" between marginal revenue product and the alternative wage is critical to a self-enforcing employment contract. It begins with a discussion of the employment contract. List of Major Concepts 1. motivation techniques must take account of the perceptions of fairness and issues of group loyalty. Productivity varies across workers and over time for a given worker. 8. the latter method requires that the measures of their performance be correlated with their effort and the employer's objectives. and deferred payment schemes. the level of pay. Workers can be motivated to be highly productive by close supervision or by having their earnings tied to their performance. 5. with the latter being incompletely specified and hence legally unenforceable. which is largely implicit and legally unenforceable. promotion tournaments and the issue of "career concerns. How this contract can be made self-enforcing within the context of asymmetric information is the principal focus of this section. 3. and the sequencing of pay. 7. 62 . " The chapter ends with a short section on two puzzles: why earnings increase with tenure and why they increase with firm size. we discuss in turn issues related to piece rates.CHAPTER 11 .PAY AND PRODUCTIVITY This chapter explores in detail the relationship between compensation and productivity. they can structure the contract so that the other party derives more from honest continuation of the employment relationship than from reneging on their promises. Thus. commissions. the parties can rely on signals that they are contracting with the "right kind" of person. we turn (in sequence) to an analysis of how motivation is affected by the basis of pay. 2. Because of group considerations. but they are useful in eliciting signals about worker characteristics. and hourly pay (including merit pay). this surplus can be created by labor investments of one sort or other. and it involves taking the initiative in a myriad of hard-to-observe ways that advance the employer's interests. efficiency wages. After discussion of some general issues relevant to worker motivation. 4. For an implicit contract to be self-enforcing. profit sharing. alternatively. 6. Schemes that tie pay to individual productivity must take account of worker risk aversion. Compensation schemes are jointly chosen by employer and employee. Contracts can be both formal and implicit.

and one way to cope with this monitoring problem is to pay higher wages. As firms increase in size it becomes increasingly costly to monitor worker effort. 19. this option promises handsome future rewards for current effort. and this may explain monopsonistic behavior among firms in the labor market. Employees who feel generously treated by their employers may put forth greater effort. Efficiency wages are most effective when the employer-employee tenure is expected to be long. Employee "career concerns" (which can involve future payoffs with other employers) can both distort and enhance efforts with one's current employer. 12. and if pay is based on objectively-measured aspects of output ("quantity").9. First. 14. 17. absolute measures do not correlate as closely with individual effort. Group incentive schemes run the risk of creating "free rider" problems. Theory suggests three reasons why. 13. hard-working employees and offers incentives for current workers to put forth effort. One scheme involves a period of underpayment followed by later overpayment. Concepts in this chapter contribute to the cluster of hypotheses that seek to explain why wages rise with tenure and why large firms pay higher wages. 18. With long expected tenures. hence. workers will put forth little effort to increase output along the other (subjective. if stability of hourly pay is preferred to the potential fluctuations of piece rate pay. the sequencing of pay is also an option. Promotion tournaments also have signaling and incentive value. but relative measures can induce counterproductive behaviors among employees. The earnings of piece-rate workers usually exceed those of hourly paid workers performing the same tasks. 10. 16. What are they? Answer. Second. Time-based pay with merit increases can be based on either absolute or relative output. Answers to Even-Numbered Review Questions 2. or "quality") dimensions. 15. then part of the "earnings premiums" enjoyed by piece-rate workers is a compensating wage differential. which has both signaling value in obtaining future-oriented. 11. Output is not normally one-dimensional. by increasing their wages employers can increase the productivity of their workers (the efficiency wage). piece-rate pay will appeal most to workers of 63 . The higher labor costs associated with greater firm size suggests that the labor supply curve to a firm may be upward sloping.

One company pays its drivers an hourly wage. Others. having paid the fee. Which agents would you predict to have the larger volume of sales. Answer. and they therefore might have a higher accident rate. Drivers paid by the piece are motivated to deliver more cases per day. This compensation plan will appeal most to job applicants who intend to 64 .00 per hour. There are two reasons to expect that agents paying an up-front fee will generate more sales. Third. and then allow the agents to keep the entire commission from each sale they make.00 per hour and putting aside $1. Suppose two soft-drink bottling companies employ drivers whose job it is to deliver cases of drinks to stores.50 per hour into a fund that they will receive as a lump-sum payment if they work through Labor Day (typically. Their incentives to make an additional sale are therefore stronger. (a) The park has apparently had trouble keeping its teenage workforce through Labor Day. They will probably drive faster so they can make more calls. 8. such workers are most likely to accept jobs paid by the piece. restaurants and businesses.above-average productivity. therefore. and in what two ways does this plan help to solve the problem? (b) Suppose the government rules that the compensation plan violates minimum wage laws because workers who quit before Labor Day receive only $4. 6. the "up-front fee" scheme calls forth signals about the agents' own expectations concerning volume (in this regard it has effects analogous to those of the "underpayment-then-overpayment" compensation scheme described in the text). 4. its biggest day of the year). An amusement park open only in the summer hires teenagers to operate its rides and concession stands. Which company is more likely to experience higher rates of traffic accidents among it drivers? Why? Answer. Second. which increases their pay. piece rates increase the incentives of given individuals to expend effort. (a) What problem is the amusement park apparently trying to solve with its compensation plan. and one would expect them to work longer hours and engage in more intensive efforts to increase their sales volume. paying them $4. Thus. How can the park now address the problem mentioned in your answer to (a)? Answer. and the other pays them by the number of cases delivered each day (which can be affected by efforts of drivers to visit and sell to new customers). Some real estate brokers split the commission revenues generated by each sale with the responsible agent. those who split all commissions with their employer or those who pay an up-front fee to their employer and then keep the entire commission? Explain. agents can keep the entire commission from each additional sale. require their agents to pay them (the brokers) money up-front. however. First. the requirement to pay the broker an "employment fee" in advance of sales will restrict interest in that kind of pay scheme to those agents whose experience and skills give them reasonable assurance they will have a high sales volume.

If workers retire after 35 years. where T = the number of years which the worker has been employed at the firm and MRPL is measured in dollars per hour. The firm will adopt the plan because it expects to profit from it -.1T. The worker's wage per hour is W = 8 + . that the discount rate for the firm is 0. For a typical worker at the firm MRPL = 10 + .) Triangle A (the initial underpayment) and triangle B (the later overpayment) are equal when T = 40 years. and that the expected tenure of a typical worker is 35 through Labor Day (that is. It could invest more in screening applicants. A firm is considering the adoption of a plan in which it would pay employees less than their MRPL early in their careers and more than their MRPL late in their careers. it has signaling value). we can find the present value of underpayments and overpayments by simply adding them up. Answers to Even-Numbered Problems 2. Assume that this wage is high enough to attract workers from alternative jobs.the early underpayments exceed the later overpayments. and it also gives current workers incentives to stay on through then. (Because the discount rate is zero. or devote more resources to supervising employees (with an eye toward persuading them to stay on the job or capitalizing on "career concerns" by providing detailed recommendations to future employers). (b) If the plan is struck down. 65 . For how many years will the firm "underpay" it workers? Answer: The graph shows the wage and MRPL lines. the park has limited alternatives owing to the seasonality of its labor demand (which probably rules out efficiency wages and other plans based on long-term attachments). substitute capital for labor. which cross after 20 years. will this plan be profitable for the firm? Explain. Triangle A exceeds triangle B if retirement comes before tenure equals 40 years.2T.

put differently. Under what conditions will incentives be most effective? Are these conditions likely to hold in this case? Answer. A recent magazine article on Japan’s economic problems stated that. Firm X is supplying the computer specialists. so tailoring incentives to deadlines might not align the interests of employer (who wants quality) and employee (who wants to meet a deadline). Both firms will share in the profits of the courses they jointly produce. we must question whether either condition is met. Japan’s lifetime-employers are carrying the cost of 66 . “As the post-war baby-boomers reach their 50s. producing a high-quality course in a brand new environment requires creativity in dealing with issues that cannot be foreseen. Firm X is working with Firm Y on creating innovative educational materials that will be used to create courses to be taught using the internet. Second. Firm X wants Firm Y to adopt financial incentives for its employees working on this project to finish their work according to a deadline. the output of Y is not completely under the control of its workers. 2. First. and when a worker’s output is only affected by his or her effort (and not affected by factors outside the control of the individual).Suggested Essay Questions 1. so delays or mistakes made by one team will affect the ability of the other to meet the deadline. X and Y are jointly producing these programs. while Firm Y is supplying the course content materials. Production incentives are most effective when they perfectly align the interests of workers and owners. In this case.

The later overpayment serves to compensate workers for their earlier underpayment. Answer. The purpose of this scheme is to provide incentives for employers to stay with the firm and work diligently (and honestly).paying their senior workers more than they are worth. and often the incentive. Yes.” Is this comment consistent with economic theory? Explain. and it is necessary to attract workers to the firm. 67 . it is consistent. lest they be discovered shirking and lose the opportunity for overpayment. to offer a payment scheme that underpays workers in their early years (wage less than marginal product) and overpays them later on (wages greater than current marginal productivity). Employers offering lifetime jobs have the ability.

" The purpose of this appendix is twofold: to give students a brief illustration of the use of regression analysis and to show them how comparable worth comparisons are made. and employee discrimination are discussed. Becker's theories of employer. customer. 2. and theories involving collusive action). Black-white earnings differentials are analyzed next in a subsection that includes a brief treatment of differences in the ratios of employment to population. AND ETHNICITY IN THE LABOR MARKET This chapter represents a comprehensive inquiry into wage differentials across gender. Income disparities between men and women may have their roots in different incentives to acquire productive characteristics. cognitive achievement. along with noncompetitive models of discrimination (occupational crowding. Current labor market discrimination is said to exist when the market places values on personal characteristics of workers that are unrelated to productivity. in which the overall differential is broken into two parts: that associated with measurable productivity differences and that associated with unobserved (unexplained) differences. RACE. The latter differences are associated with (but not confined to) current market discrimination. Discrimination is defined and problems of its measurement are discussed in the context of analyzing gender differences in earnings. It begins with a section on earnings differences by gender. racial and ethnic groups. and the theory of statistical discrimination is explained. with special emphasis on the effects of such hard-to-observe factors as English language proficiency. The chapter closes with an analysis of the federal contract compliance program. List of Major Concepts 1. The second major section of the chapter analyzes theories of market discrimination. the analysis includes a review of attempts to estimate the effects of discrimination. 68 . In each case. including the standards against which affirmative action plans are judged and the results of studies that have tried to assess the effects of the program. The chapter concludes with in-depth discussions of governmental efforts to reduce or eliminate market discrimination: the Equal Pay Act of 1963 and the Civil Rights Act of 1964. legal decisions involving seniority. The appendix to Chapter 12 contains an introduction to the problems of estimating comparable worth "earnings gaps.GENDER. dual labor markets. and school quality.CHAPTER 12 . Included in our discussion of the last are the evolution of the disparate impact standard by the courts (as opposed to a disparate treatment standard). and the emerging comparable worth remedy. Earnings by ethnicity are also discussed. search-based monopsony.

13. 7. and it could reflect the effects of unmeasured worker characteristics as well as market discrimination. Much of what appears to be labor market discrimination against women takes the form of occupational segregation. Under employer discrimination." 4. Human capital and language-proficiency differences account for A but 3 to 7 percentage points of the Hispanic wage differential. seems to be declining somewhat recently. 10. 9. the behavior of prejudiced employers will reduce demand for the minority group and cause a wage differential to exist. 6. one must determine what the earnings ratio would be if the protected class and white males had the same productive characteristics. Differences in the black-white employment-to-population ratio are a function of both higher unemployment rates and lower labor force participation rates among blacks.3. When productive characteristics are controlled in an analysis of earnings differentials. and those who are the most discriminatory will make the least profits. Studies that control for cognitive achievement scores as well suggest that black men earn from 8 percent more to 8 percent less than white men with comparable productive characteristics. Thus. 11. The implication that prejudiced employers will be less profitable suggests that discrimination ought to be eliminated over time as nonprejudiced (profitable) employers buy out less profitable. 69 . The size of the differential depends on the size of the minority population relative to the distribution of prejudiced employers in the market. they will act as if they believe the marginal product of those workers is lower than it really is. However. they will hire fewer such workers than would be called for by profit maximization. To measure the extent of wage discrimination. 5. Studies using convention ally-measured variables for productive characteristics suggest that about 11 percentage points of the observed disparity between black and white males may be due to current labor market discrimination. the adjusted differential is in reality an unexplained differential. 8. 12. they account for all but roughly 10 percentage points of the gender wage differential. If employers discriminate against some group of workers. it is difficult to distinguish between the effects of occupational choice and those of employer discrimination. which. Occupational segregation is one form of discrimination. while still rather marked. prejudiced employers. and it can be measured by an index of occupational dissimilarity. Earnings differentials caused by differences in productive characteristics are termed "premarket. however.

However. 15. 19. 18.14. 20. but they do not satisfactorily explain the creation of these groups. 16. customer discrimination implies a shift to the left of the demand curve for the services of a protected class. Employee discrimination generates supply-related behavior that might cause employers to segregate their plants by race or sex if possible. and if discrimination raises the search costs of certain groups of workers. that counts. Both the crowding hypothesis and theories emphasizing the dual labor market suggest the presence of noncompeting groups. If not. Some theorists use collusive action on the part of employers to explain the creation and persistence of noncompeting groups. by which it is labor market results. Statistical discrimination should be reduced in situations in which the variance of individual characteristics around the group average widens. 21. Under this standard. not motivation. policies that lead to different effects by race and sex are prohibited unless a business "necessity" can justify their use. If search costs create upward-sloping labor supply curves to individual employers. wage differentials will arise as a result of the need of employers to retain workers in the prejudiced group. a reduction in productivity is. 22. then monopsonistic behavior will create wage differentials among otherwise identical workers. and policies that may appear to be neutral on the surface may nevertheless perpetuate the effects of past discrimination. If employment standards are the only ones used. 70 . Statistical discrimination arises from a screening problem in which job applicants are evaluated both on their individual characteristics and on average characteristics of the group to which they belong. Like employer discrimination. but the theory does not explain how an employer cartel is maintained in the face of clear-cut incentives to cheat. If a wage standard is the only one applicable. genuine. from the employer's perspective. Courts have moved towards a disparate impact standard. Employers are seen as deliberately dividing the labor force to guard against cohesive collective action by workers. Proving intent is difficult. Anti-discrimination programs by the government must set standards for both employment and wages. with customer discrimination. A disparate treatment standard imposed under the Civil Rights Act judges that discrimination has occurred if different procedures are used for different groups of people and if it can be shown that there was an intent to discriminate. then prejudiced employers will respond to increased wages for protected classes by reducing employment. prejudiced employers may comply by paying protected-class workers less than white males. 17.

the existence (and size) of labor market discrimination depends on the wage gap between unskilled native whites and unskilled Mexican immigrants (that is. The Federal Contract Compliance Program seeks to shift the demand curve for protected classes to the right. men and women often occupy dissimilar jobs. This growth means that measured labor market discrimination against unskilled Mexican immigrants is also growing. Labor market discrimination is said to exist when workers who are productively equivalent are systematically paid different wages based on their race or ethnicity (or some other demographic characteristic unrelated to productivity). the willingness of workers to commute to the firm. and working conditions in jobs for purposes of pay comparisons. Answers to Even-Numbered Review Questions 2. the wage gap between skilled and unskilled workers in the United States has grown. Answer. 25. (Appendix) Estimating comparable worth earnings gaps typically involves evaluating characteristics of jobs for men and women and estimating the relationship between these characteristics and compensation for white males. However. Realistic estimates of availability should account for the compensation policy of the firm. the degree to which the firm has incentives to train new employees. This relationship can then be used to estimate what women would receive if they were paid on a basis comparable to men.” Comment on whether the second part of this statement is implied by the first part. 24. Studies to evaluate the effects of government anti-discrimination efforts have focused on time series analyses of earnings ratios and effects on federal contractors (emphasizing changes in employment levels. however. wages. and the extent to which job applicants can be induced to move to the firm's labor market area. mandating wage increases for women could reduce the incentives of employers to hire them. responsibility.23. The estimated coefficient on the point score variable is an estimate of how much a unit change in that variable affects earnings. 71 . (Appendix) A precise and informative way of estimating the relationship between point scores and compensation would be to use ordinary least squares regression techniques to fit the "best" line through the observed points on the graph. Federal contractors are required to file affirmative action plans that state their goals for hiring and promoting members of protected classes (taking account of "availability"). It is true that rising inequality causes a greater gap between the average wages of native whites and unskilled Mexican immigrants. The comparable worth remedy is based on comparing the skill content. 26. and quit rates for protected-class workers). Because of occupational segregation. on average. 27. “In recent years. because native whites are better educated and more skilled. 28.

the employer clearly prefers to hire men over women of comparable productive characteristics. 6. it does not seem to exhibit this latter behavior. Employer discrimination can be observed in two instances. Thus. it is not obvious that this particular university is engaged in the behavior we could attribute to employer discrimination. You are involved in an investigation of charges that a large university in a small town is discriminating against female employees. suburban districts that recruit teachers from the same pool. by hypothesis. because these schools can attract the white teachers without offering a compensating wage differential. also. but white teachers are reluctant to take jobs in the central city (assume their prejudice extends only to students. There are different relative demands and supplies by academic field that are reflected in differential salaries. or less than white teachers? Why? Answer. Black teachers are equally willing to teach in both places. will black teachers earn more. these schools must attract white teachers who. not to black teachers). the central city schools must raise wages (this wage increment would act as a compensating wage differential. Because salaries for all teachers within a school district must be equal. 4. The other occurs when. Whatever the cause of the large relative supply of women to the social work field. 72 . central-city school district surrounded by white. Assume there is a predominantly black.between two productively equivalent groups) – so the facts quoted in the statement are not sufficient to determine if labor market discrimination is growing. to attract enough white teachers to fill the job slots. Wages in the suburban schools will be lower than the wages in central city schools. Because black teachers. prefer to teach in suburban schools. Professors of social work. may receive relatively low wages because the supply of labor to that field is greater relative to demand. the same. the employer fails to hire an all-female work force. are equally willing to work in central city or suburban schools when wages are equal. Is this university exhibiting behavior associated with employer discrimination? Answer. given a lower market wage for women relative to comparable men. Because there are too few black teachers to completely staff central city schools. Assume further that there are not enough black teachers to fully staff the central city schools. One occurs when. If the law requires teachers in the same district to paid equally. but allows salaries across districts to vary. compensating white teachers for taking jobs they might otherwise find "distasteful"). therefore. You find that the salaries for professors in the nearly all-female School of Social Work are 20 percent below average salaries paid to those of comparable rank elsewhere in the university. with equal wages for men and women. Because the university has apparently hired a nearly all-female work force in the School of Social Work. by hypothesis. the black teachers in the central city schools must receive the higher wages there. suburban schools will not be able to attract black teachers (who will find the higher wage at the central city schools more attractive).

however. then L = 20 workers for a profit-maximizing employer. then L = 16 for employer A. The effects of the law on black Africans were unambiguously adverse. Those who would have chosen to obtain training for skilled positions were not able to do so.. were probably made worse-off by this law because of its effects on the unskilled wage. of $2 per hour.5L when profits are maximized. Graph the MRPL curve and show how many left-handed workers employer A hires. Because 10 = 20 . 73 . however. would have elected to obtain the training necessary for entrance to a skilled trade. but employer A discriminates against these workers and has a discrimination coefficient. The effects of the laws on white workers were ambiguous. Analyze the consequences of this law for black and white South African workers. In the 1920s South Africa passed laws that effectively prohibited black Africans from working in jobs that required high degrees of skill. Answer. D. will hire left-handers until wage + D = MRPL. in the sense that they received higher wages than they would have received otherwise (had blacks been allowed into the skilled trades). where L = the number of lefthanded workers and MRPL is measured in dollars per hour. How much profit has employer A lost by discriminating? Answer: See the figure.. Lost profits equal triangle ABC. A non-discriminating employer will hire left-handers until wage = MRPL. Since 10 + 2 = 20 . however. Unskilled whites. Answers to Even-Numbered Problems 2.8. for which the wage was driven down still further by the requirement that blacks could not do other work.5L for left-handed workers. Employer A. skilled jobs were reserved for whites. whose area is 4 x $2 x .5 = $4 per hour. The going wage for lefthanded workers is $10 per hour. reacting to the increased wage differential between skilled and unskilled jobs. Some unskilled whites.. Suppose that MRPL = 20 . Skilled white workers were helped. Blacks were crowded into low-paying unskilled occupations.5L.

reducing their employment from 60 to 40. so W = $15 per hour Plugging this into the two equations shows that. 74 . The calculation for librarians is as follows: -15 + 5W = 180 – 10W. If the librarians' wage were increased to $15 per hour. In the market for librarians. or 15W = 225. Answer: To find the equilibrium wage for truck drivers. Ls = -45 + 5W and Ld = 180 – 10W.4. Find the equilibrium wage and employment level in each occupation and explain what will happen if a comparable worth law mandates that the librarian wage be increased to equal the delivery truck driver wage. employers would move back along the Ld curve from point A to point B on the figure below and hire fewer librarians. for truck drivers. or 15W = 195. where L = number of workers and W = wage in dollars per hour. so W = $13 per hour For librarians. L = 30. Ls = -15 + 5W and Ld = 180 – 10W. Use a graph. set Ld = Ls and solve for W: -45 + 5W = 180 – 10W. (Appendix) In the market for delivery truck drivers. L = 60.

or when consumers substitute other goods or services for the one in question). profit-maximizing employers will prefer to hire workers from groups that customers do not have distaste for. Answer. requiring them to hire and pay qualified minorities in proportion to their availability will not reduce profits. If the law requires employers to hire from all groups proportionately. (It will.Suggested Essay Questions 1. however. reduce the utility owners derive from their businesses. firms previously attracting prejudiced customers will lose business (either to firms that might not be covered by the law.) 2. however. thus. they will tend to avoid businesses hiring workers from groups they are prejudiced against. Will government-mandated requirements to hire qualified minorities (at nondiscriminatory wages) in the same proportions they are found in the relevant labor force reduce the profits of firms that formerly engaged in employer discrimination? Fully explain your answer. their costs could go down now that there is no reason for paying a premium to workers 75 . Will government-mandated requirements to hire qualified minorities (at nondiscriminatory wages) in the same proportions they are found in the relevant labor force reduce the profits of firms that formerly faced customer discrimination? Fully explain your answer. Firms that engage in employer discrimination forgo profits in order to indulge their prejudices. Answer. Thus. If customers are prejudiced.

from “favored” groups. so their costs will rise. 76 . Firms previously attracting non-prejudicial customers will now be unable to capitalize on the lower demand (and lower wages) for minority workers.

before turning to elementary coverage of major pieces of labor legislation in the United States. we turn to an analysis of the effects of unions on wages and other workplace outcomes. The measurable effect of unions on wages is the relative wage advantage. The appendix to Chapter 13 analyzes how the uncertainty of arbitrators' decisions affects bargaining outcomes. No discussion of union behavior would be complete without an analysis of strike activity and (for the public sector) interest arbitration. List of Major Concepts 1. 2. in which the union and firm jointly bargain over wage and employment levels. The section on strikes include an exposition of the Hicks model of bargaining and the Ashenfelter-Johnson political model of strike behavior (including the effects of the Landrum-Griffin Act). Unions facing relatively inelastic demand curves are better able to raise wages without adversely affecting employment levels very much. productivity. It begins with some necessary definitions and descriptions of unionism in the United States compared to elsewhere in the world. The true (or absolute) effects of unions on wages are not measurable. in which the union sets the wage and the employer adjusts by setting the employment level. Having analyzed some key characteristics of union behavior. in both the private and public sectors. We use this analysis to help understand the major trends in American unionization. Union membership as a fraction of the population in the United States is low relative to the other major industrial countries. In seeking their objectives.. As in the appendix to Chapter 8. We close the chapter by summarizing empirical evidence on the effects of unions on relative wages. In attempting to explain the major activities of unions. A more complex model is the "efficient contracts" model. Unions are constrained in their objectives by the labor demand curve. The section on arbitration discusses the contract zone in the context of both conventional and final-offer arbitration. found by comparing union wages to wages in the nonunion sector. total compensation. and the possible biases inherent in measuring the absolute effects using relative-effect measures are discussed at length. and discuss both "traditional" and alternative views of union effects on the overall social welfare. the discussion defines and illustrates the concept of risk aversion. 77 . The simplest model of unions' objectives is the "monopoly union" model. unions are constrained by the demand for their members' services.CHAPTER 13 . we have organized the analysis around the demand for unions by workers and the supply of union services by labor unions.UNIONS AND THE LABOR MARKET The major focus of this chapter is on the economic effects of unions. and profit. and American union activities are relatively decentralized. employment.

78 . may pursue the twin goals of maintaining their positions in the union and educating union members by recommending a strike. the resulting employment/wage outcome will be inferior to another set of outcomes that would improve the welfare of both parties. Union leaders. The monopoly-union model assumes that the union sets the wage and the employer sets the employment level. one party wants to elicit a signal from the other about its true preferences or constraints. The "efficient-contracts" model emphasizes that if unions and employers bargain only over wages. Unions' propensities to strike vary over the business cycle and have trended down over time. 9. 10. both sides become more willing to make concessions as strike duration increases. but because they also impose costs on employees. where strikes are generally not permitted. competitive pressures. Under this model. but the increase in union democracy associated with the Landrum-Griffin Act caused a one-time increase in strike activity (as predicted by the AshenfelterJohnson model). the two parties bargain over both wage and employment levels. The Hicks bargaining model suggests when strikes will end. who have better information than their members. 7. Interest arbitration is used in the public sector. and employer resistance). but it does not explain why strikes occur in the first place. by reference to shifts in the demand and supply curves for union services (caused by the feminization of the work force. While strikes can occur because one party mistakes the other's true position. The Ashenfelter-Johnson model of strike activity. which is tripartite in nature. The decline in American union membership can be understood. Unions often take actions designed to shift the demand curve for labor to the right and/or to reduce the elasticity of demand for union labor. 8. in the context of asymmetric information. in part. Strikes are intended to impose financial costs on employers if they do not agree to union offers. regional shifts. 6. However. 5. and interest arbitration can be "conventional" or "final offer. views union leaders and union members as sometimes having conflicting perspectives." 12. 4. 11.3. a change in industrial composition. it is not clear whether a wider contract zone increases or reduces the chances a dispute will go to arbitration. they can also occur because. The "contract zone" into which pre-arbitration offers will fall can be widened by both the uncertainty about what an arbitrator might decide and the parties' aversion to the risk of an adverse outcome.

has an ambiguous effect on productivity. 18. the presence of unions should lower the nonunion wage below what it would have been otherwise and cause the relative wage effect to overstate the absolute effect of unions. 20. and strikes. The compensation advantages enjoyed by union members. In an overall sense. These wage effects are larger in the private than the public sector. measuring this absolute wage advantage is impossible. Whether wait unemployment causes the relative wage effect to be greater or smaller than the absolute wage effect depends on whether the supply curve of labor to the nonunion sector shifts to the right or left. but this is not a good measure of the absolute effect because the presence of unions alters the nonunion wage also. Empirical evidence tends to suggest that. restrictive work practices. and largest among unskilled (and minority) workers. in the United States. One would like to measure the effects of unions on wages in the absolute (comparing wages in a world with unions to wages in a world without). and a negative effect on profits. unionization reduces employment or employment growth. but employer resistance to 79 . however. 16. larger in the United States than elsewhere. may be in part a compensating wage differential for the more structured. however. the relative wage effect is smaller than the absolute union wage effect. 22. If employers raise wages in the nonunion sector to keep unions out (thus creating unemployment in that sector). The traditional view of union effects stresses the social loss caused by inequality in wages (and marginal productivities) among workers of comparable skill. 19. thus. the total compensation effects of unions may be greater than the relative wage effects. The presence of wait unemployment in the union sector will inhibit the growth in labor supply in the nonunion sector and could even cause the supply curve there to shift left. The alternative view of unions is that they provide a method of collective "voice" that tends to reduce turnover and encourage firms to provide specific training to employees. 14. more hazardous and less flexible work settings in unionized firms. unions appear to raise the wages of their members above the nonunion wage by something like 10 to 20 percent. The traditional view also stresses the losses associated with union staffing requirements. 15. We can only measure union wages relative to nonunion wages.13. 21. If the nonunion labor market is in equilibrium. Union effects on employee benefits as a percentage of total compensation tend to be positive. 17. Improved communications between labor and management may also increase productivity and worker motivation directly.

how can this pattern be explained? Answer. a. Using economic theory. which will mitigate the amount of capital/labor substitution that might otherwise accompany a union standards clause. employers are not adding to their capital stock or opening new plants. (a) The union's goal for seeking the union standards clause is to remove incentives for the employer to substitute cheaper nonunion labor for more expensive union labor. if the product demand curve is relatively inelastic (so that scale effects are small). Analogously. (b) The ultimate goal of the union. It has been observed that unions in the capital-intensive steel industry were able to negotiate higher-than-average wage increases during the very period in which steel output in the United States was declining. 23. is to raise wages while preserving employment (or at least not having to undergo large employment declines). Some collective bargaining agreements contain "union standards" clauses that prohibit the employer from farming out work normally done in the plant to other firms that pay less than the union wage. any tendency to substitute capital for labor will be met with a rising price of capital. the range of possible nonarbitrated settlements is widened by greater uncertainty about how the arbitrator will decide (if an agreement is not reached) and by greater risk aversion on the part of the parties. When output is contracting. of course. the union standards clause will be more successful in preserving employment of union members if the firm finds it more difficult or expensive to substitute capital for labor within the firm. when output is contracting.unions and the degree to which stock market prices are depressed when union organization drives are initiated suggest a widespread belief that unions reduce profitability. A union standards clause will be more attractive to a union when the firm can more easily substitute outside factors of production for those it employs and when these substitution effects are large. The 80 . 4. However. so technological improvements that substitute capital for labor are not easily made. a union standards clause will be more successful in preserving employment. one would think that the shrinking demand for workers (owing to the scale effect) would reduce a union’s ability to negotiate wage increases without harming job opportunities for its members. if the supply of capital to the firm is relatively inelastic. What is the union's rationale for seeking a union standards clause? b. Under what conditions will a union standards clause most likely be sought by a labor union? Answer. Moreover. and therefore more sought-after. Likewise. (Appendix) When collective bargaining impasses can be decided by arbitration. Answers to Even-Numbered Review Questions 2.

and 10 percent know for sure that they will be. please answer the following: a. The traditional view is that when workers of comparable potential are in jobs with different productivities. 6. the high-productivity jobs. it is a safe bet that they would act in the interests of the majority (who would not be laid off) and would therefore choose to maintain current salaries and accept layoffs of 10 percent. in advance of the decision that must be made by the union. Therefore. In this case. or it could keep salaries constant and accept a 10 percent cut in employment levels (and a corresponding ten percent increase in class sizes). However. Answer. Alternatively. they may enhance society’s total output. although they probably would if their workers were risk averse. society’s output could be increased if some moved from the low. In either case. Is the following statement true. 81 . A simple political model of union decision making could not predict for sure that unions would accept salary cuts in this case. it is much more likely that the union would choose to accept salary cuts than cuts in employment.reduced ability to substitute capital for labor serves to strengthen the union’s hand. teaching field. assuming that its collective bargaining agreement with the city specifies that any layoffs will occur among those teachers most recently hired. then each union member has a 10 percent chance of being laid off if salaries are held constant. (a) If layoffs occur only among the most recently hired. because even if wages rise the substitution of capital for labor may not take place. Answer. Explain whether the decision in (a) would have been different if the collective bargaining agreement had specified that all layoffs would occur on a random basis. Given that union leaders are elected by the membership. 90 percent of all union members will know that they will not be laid off.” for example). b. or uncertain? “The empirical studies indicating that unions raise the wages of their members by 10 to 20 percent relative to the wages of comparable nonunion workers imply that unions have a negative effect on national output. independent of seniority. the chances of the union's deciding to accept employment cuts are much lower. each worker would face a 10 percent decrease in expected wages. Because the union leaders who had to make this decision are elected by majority rule. compared to the case in which layoffs are made among those most recently hired. members could accept a 10 percent cut in their salaries with the assurance that they would not be laid off. if unions solve problems created by market imperfections (workers can use “voice” rather than “exit. it is possible for each union worker to calculate whether he or she is among the group to be laid off. false. 8. (b) If layoffs are to be made randomly. Predict and explain the union's decision. In the mid 1980s the teachers' union of a large American city was given a choice: it could accept a 10 percent cut in the salaries paid to teachers and suffer no employment losses. or any other teacher characteristics.” Explain your answer.

some workers. selling. but have no power to directly set employment levels. The Dog Catcher's International faces an own-wage elasticity of demand for its labor that equals -3. the scale of output will fall owing to the boycott. distributing) that depend on the scale of output produced both in the U. In the case of the Dog Catchers this implies -3 = %(quantity demanded)/20%. we would expect that consumers would tend to substitute American goods (now relatively cheaper) for foreignmade goods. If so. Clearly. thus employment will fall by 60% if they boost wages by 20 percent. the demand for American labor may rise.S. output price will tend to rise and only those consumers willing to pay the higher prices will remain in the market. and these workers may end up losing their manufacturing jobs and having to go back to farming or some other job they previously felt was inferior. Boycotting goods made by workers in “sweatshop” conditions. therefore. (b) If manufactured items from abroad become more expensive.1.Answers to Even-Numbered Problems 2. Why might members of the Dog Catcher's International be more wary of the targeted wage increase? Answer: Own-wage elasticity of demand = %(quantity demanded)/%(wage). we must also consider the scale effects associated with higher costs overseas. given their preferences and opportunities. and the costs of producing the items in question will rise. thus employment will fall by only 2 percent if they boost wages by 20 percent. and if this substitution effect is dominant. However. then.1 = %(quantity demanded)/20%. and these workers will be worse off if the boycott lasts and is successful. Suggested Essay Questions 1. Answer. (a) If manufacturers in these less developed countries are induced to raise wages and improve working conditions. may be gross complements with foreign workers. will these efforts unambiguously help the targeted foreign workers? Explain fully.0. and abroad. Thus. when the costs of foreign labor rise. American unions often try to win public support for boycotting goods made in less developed countries by workers who work very long hours at low pay in unhealthy working conditions. foreign and American workers may be considered substitutes in production. In the case of the Brain Surgeons this implies -0. 2. This country is thinking about adopting a bargaining 82 . (b) Will they unambiguously help the union’s American workers? Explain fully. tends to reduce demand (because of both scale and substitution effects) for the services of low-wage labor. (a) If successful. A certain country has very centralized collective bargaining. Some American workers may have jobs (in packaging. under which wage bargains are applied nationally. the will be gross substitutes. Suppose that leaders in both unions push for a 20 percent wage increase. The Brain Surgeon's Brotherhood faces an own-wage elasticity of demand for its labor that equals -0.

Thus. Union power to raise wages is affected by the elasticity of demand for its workers. while those with elasticities less than the national aggregate would bargain for less. because if it is able to raise wages in all sectors. and less in other. we might expect wage increases to be larger. Answer. A national union may perceive the product demand (and hence labor demand) of employers to be relatively inelastic. however. given wage increases will result in greater loss of employment. the unions involved in wage setting will perceive the output demand elasticity to be relatively elastic. When bargaining is very decentralized. Thus. and they may moderate their demands as a result. however. where elasticity is higher. All employers will face higher wages and higher costs – and thus have higher prices – although the degree to which their output prices will rise depends on the share of labor in total cost and their ability to substitute for labor in the production process. we would expect that local unions facing labor demand elasticities that are lower than the national aggregate to bargain for greater wage increases than they got under centralized bargaining. At a more disaggregated level. How would you expect decentralization to affect wages and employment? Explain why.structure that is more decentralized. 83 . so that wage bargains will be made at the individual plant or firm level. and employment losses to be larger. wage increases will be greater than what they would have been under centralized bargaining in some sectors. Overall. with centralized bargaining. consumers have limited incentives for substituting goods from one sector for goods from another. a greater ability to tailor local demands to local elasticities should result in a reduced level of job loss associated with unionization. at a broad level of analysis.

with the conclusion that demand factors were dominant in the 1980s (especially computerrelated technological changes that affected the mix of productive factors. or labor demand changes. The most notable change in earnings for both men and women was the increase in the relative earnings of more-educated workers. 5. Earnings inequality is a function of the dispersion of the earnings distribution. leading to increased relative demand for educated workers). and this dispersion can be measured in various ways. 3. The appendix discusses the derivation of Lorenz curves and Gini-coefficients. institutional changes. relative wages. Empirical studies are surveyed. List of Major Concepts 1. which differ in the ease with which they can be completed and widely understood. The underlying causes of growing inequality are then grouped into supply factors. The most widely-used measures involve ranking the population and analyzing earnings by percentile (comparing either shares of the total received by a group or the earnings levels at percentile boundaries).CHAPTER 14 . hours of work. and earnings dispersion within narrowly-defined human capital groups. Earnings also became more dispersed within human-capital groups. 2. 4. for men this increase occurred mainly because earnings of the less-educated fell in real terms. 8. 7. while for women it was associated mainly with the increased real earnings of more-educated women. 84 . Growing disparities could result from labor supply.INEQUALITY IN EARNINGS This chapter is intended to accomplish two purposes: to analyze changes in earnings inequality after the 1980s and to review major concepts of economic theory introduced in prior chapters. 6. and demand-side influences. more because wages of those in the upper end grew relative to others' than to a movement of jobs from the middle of the distribution to either end. The returns to experience rose modestly. Changes in the relative hours of work played no role in the growth of inequality. It begins with a section on measuring inequality and then moves to one that describes changes in the 1980s and early 1990s along various dimensions: the occupational distribution. but only for the less-educated. institutional. Earnings distributions for both men and women became "stretched" in the 1980s.

Proposals to tax health and other employee benefits. which are not now subject to the income tax. analyze the effects of comparable worth on earnings inequality among women. there may be downward pressure on wages in femaledominated jobs in the small business sector as employment shifts from sectors experiencing large wage increases to "uncovered" sectors. while those slightly above them will experience wage increases. In summary. it is possible that the lowest-paying jobs with the lowest-paying employers will actually experience reductions in wages that could widen the dispersion of earnings. Raising the wages of the lowest-paying jobs will tend to equalize the distribution of earnings.) Answer: The comparable worth remedy will have contradictory effects on the dispersion of earnings if it is applied only to large private or governmental employers.9. The fact that skilled employment grew faster than unskilled employment in the 1980s appears to rule out supply changes as the dominant factor underlying the growth of inequality. 4. with the latter changes the dominant force in the growth of education-related differentials. see Chapter 12. the more dominant of these two tendencies is difficult to forecast. Assuming that more highly paid workers have higher employee benefits. (Appendix) The Lorenz curve and Gini coefficient are related measures of disparities that are based on groups' shares among the total. see Chapter 8. have been made in recent years. Answers to Even-Numbered Review Questions 2. but because the remedy applies only to the highest-paying firms. but definitive work has yet to be done. Both product demand changes and changes in the mix of productive factors contributed to growing inequality. Assume that the "comparable worth" remedy for wage discrimination against women will require governmental and large private employers to increase the wages they pay to women in female-dominated jobs. 12. In particular. The remedy will not apply to small firms. (For a review of relevant concepts. but they apparently played a minor one. women in the very lowest part of the income distribution might experience wage reductions. The reason is that the employers to which the comparable worth remedy will apply are the highestpaying employers. (For a review of relevant concepts. 13. Such institutional factors as a "frozen" minimum wage and declining unionization could have played a role in the growing inequality. analyze the effects on earnings inequality if these tax proposals are adopted. 10.) 85 . but the jobs to which it will apply are among the lowest-paying jobs. Thus. there may be offsetting tendencies. 11. Given what you learned earlier about wages by firm size and in female-dominated jobs. The growth of contingent-pay plans might underlie the increased dispersion within human-capital groups.

If by the "earnings distribution" we mean (as we did in the text) cash earnings. Discuss the role of geographic mobility in decreasing or increasing the dispersion of earnings. Assuming overall (pre-tax) compensation levels are not changed by this new law. but boosts wages to $7 per hour in sector B. Sector A B C Number of Workers 50 25 25 Wage $10 per hour $5 per hour $5 per hour Then a minimum wage law is passed that doesn't affect the market in high-wage sector A. is more equal than before. its main effect will be to shift the compensation of highlypaid workers away from benefits and toward even higher levels of cash earnings. the receipt of compensation in the form of "in-kind" or deferred benefits becomes less attractive. owing to the increased taxes paid by highly-compensated workers. is offset by a narrowing of the dispersion of employee benefits received. while reducing employment to 20. Suppose that the wage distribution for a small town is given below.driving up wages in low-wage areas (as workers move out) and driving down wages in high-wage areas. with the result that the overall distribution of total pre-tax compensation might remain essentially unchanged. see Chapter 10.) 6. at least in part. Widening the dispersion of earnings. however. however. Answers to Even-Numbered Problems 2. then the effect of this benefits tax will be to widen the dispersion of earnings in society. People tend to move from areas with low opportunities (wages) to places where they believe they can improve their earnings. where wages fall to $4. Thus. (For a review of the relevant concepts. Workers now receiving a substantial fraction of their overall compensation in the form of benefits may decide that they would prefer to have reduced benefits and receive a higher fraction of their pay in cash earnings.50 per hour as employment grows to 30. Has wage inequality risen or fallen? Explain. (The distribution of post-tax compensation. a response to earnings inequality across geographic areas. While geographic mobility may do little to shrink the gap between the wages of highlyeducated workers and those of high school dropouts say it does serve to reduce the disparity of earnings within human-capital groups. at least in the long-run. Displaced workers in sector B move into sector C. the covered sector.Answer: If employee benefits are subjected to the income tax.) Answer: Geographic mobility is. geographic mobility should tend to equalize earnings across areas -. 86 .

technological change does not imply anything about changes in wage equality. these sectoral shifts do not depend on wage levels alone). there are different ways of measuring wage inequality. wages rise for some low-wage workers. X and Y now agree to drop these tariffs. Would a higher minimum wage promote more wage equality? Discuss thoroughly. depending on the ratio of marginal product to wages for the two kinds of workers in X and Y (clearly. As discussed in Chapter 4 and its appendix. Suggested Essay Questions 1. which have had the effect of reducing trade between the two countries. In this case.Answer: There are several ways to measure inequality. As discussed in Chapter 4. thus wage inequality has fallen by this measure. an 80-20 measure would show improvement. Answer. but a 90-10 measure would indicate greater inequality. Historically. and less of another. moving from restricted to free trade will have effects similar to technological change (in that the principle of comparative advantage will lead to more efficient production of goods and services). the share of income going to the bottom half of the income distribution has risen (from $250/$750 = . while those who are uncovered are at the 10th.22). which can now take advantage of cheaper goods and services. (Of course. On the other hand.) 2.355). There is no unambiguous answer to this question. On the one hand. Will greater trade between the two countries lead to increased real incomes in each country? Will greater trade lead to increased real wage equality within each country? Answer. 87 . Technological change will increase real incomes in both countries. if workers covered by a new minimum wage were at the 20th percentile of the wage distribution. and different results could be obtained by different measures. they have levied tariffs on each other’s exports. However.333 to $275/$775 = . Countries X and Y both have agricultural and industrial sectors. For example. the 80th-20th percentile wage ratio has risen (from $10/$5 = 2 to $10/$4.50 = 2. but fall for others – and the effects on wage inequality are ambiguous. Comparative advantage may call for more of one kind of worker in a given country to be used. one possible effect of a higher minimum wage is for the “spillover effect” to cause lower wages in the uncovered sector.

Since the receipt of unemployment insurance benefits reduces the costs of extra time spent searching for work. Further. the financing of unemployment benefits. focusing only on the stock masks the highly dynamic nature of labor markets. and the extent to which someone will spend time searching for work depends upon the expected benefits and costs of continuing search. new hires and recalls. and sex composition of the labor force on the full employment rate of unemployment. 3. retirees from and new entrants into the labor market.CHAPTER 15 . Government efforts to improve the rapidity of the job-matching process could reduce the extent of frictional unemployment. List of Major Concepts 1. In the section on frictional unemployment we discuss search theory and the effects of unemployment benefits on job search. and policies and adjustments found in Europe. we discuss four general types of unemployment: frictional. more generous 88 . Thus. 2. As these flows change relative to each other. and seasonal unemployment. When analyzing structural unemployment. there is an underlying set of flows into and out of that stock. The chapter also treats the issue of "full employment. the more generous these benefits are. The section on demand deficient unemployment analyzes wage rigidity. the longer unemployed workers will tend to search for jobs. race. Frictional unemployment occurs because labor market information is imperfect. 4. different demographic groups may have different unemployment rates because of different propensities to quit or be laid off from jobs. structural. demand deficient. 5. it emphasizes that while the unemployment rate is a stock concept. It takes time even in the best of markets for unemployed workers and employers with job vacancies to find each other. Thus." The structure of unemployment rates across demographic groups is presented. Unemployment rates are affected by layoffs and quits. A period of unemployment can be looked upon as a period when job search can be undertaken. While this measure has a number of serious drawbacks. While one can think of a stock of unemployed persons. the unemployment rate changes in predictable ways. this stock is constantly changing. The unemployment rate is the number of nonemployed people seeking work divided by the number of people who are in the labor force. it remains a useful indicator of labor market conditions. occupational and geographical imbalances. and efficiency wages (including the "wage curve") are discussed. and we then discuss effects of the changing age. government policies.UNEMPLOYMENT This chapter defines the unemployment rate and discusses its strengths and weaknesses as a measure of economic welfare. Next.

in such cases. 7. 11. unemployment in "normal" times) appears to have changed in recent years. some workers without jobs "wait" for jobs in the high-paying sector and do not seek jobs in lower-paying firms.unemployment insurance benefits may be expected to increase the duration of unemployment. In Europe. concerns about status. The full-employment rate of unemployment (i. risk aversion of older workers. Efficiency wages may underlie the "wage curve" found in almost all countries studied. in part due to the changing proportion of women. 12. but it is also affected by downward rigidity of money wages and the government's unemployment insurance program. Demand-deficient unemployment occurs when the aggregate demand for labor declines in the face of downward inflexibility of nominal or real wages. Structural unemployment is also associated with firms' decisions to pay efficiency wages. the asymmetry of information between employers and employees. 8. One reason for the greater adjustments in hours of work may lie in the wider use of partial unemployment compensation benefits in Europe. including the preference of unions for layoffs over wage cuts. There are several reasons for the downward inflexibility of money wages..defined by skill or geography -. 10.e. Seasonal unemployment may be associated with changes in the weather or with model changeovers. Answers to Even-Numbered Review Questions 89 . not employment levels. 6. and ethnic minorities in the labor force. Structural unemployment occurs when flows of workers into and out of particular labor markets -. 14. The government's tax treatment of most unemployment insurance benefits and its failure to perfectly experience-rate the unemployment insurance charges levied on employers lead to a higher layoff rate than would otherwise prevail. when the risk of layoff is high. teenagers. yearly earnings of workers will stabilize. and implicit contractual agreements that after an initial period. 13. Government efforts to subsidize mobility and/or job training would serve to reduce the incidence of structural unemployment. 9. this curve plots a negative relationship between the regions' wage rates and their unemployment rates. firm-specific training.are impeded. cyclical fluctuations in labor demand are more likely to be manifest in adjustments in hours.

taken as a whole. employment. It tells us nothing about the number of workers who are employed. then the substitution of training periods for periods of unemployment may 90 . It tells us nothing about whether the employed are working at jobs commensurate with their skill levels. Three were notable: (1) Plants that provided in-plant training instead of laying off workers in a recession received government subsidies.2. have on wages. The benefits of higher UI benefits are the better job matches they induce. (2) All workers had to be given at least one month's notice before being laid off. The empirical magnitudes of these various effects must be evaluated before one can decide if it is desirable to raise UI benefits. however. In the 1970s Sweden adopted several new labor market policies affecting layoffs. as they provide unemployed workers with the resources to continue to search for jobs more commensurate with their skill levels. (3) Laid-off workers had to be given first option on new jobs with the former employer." Explain your answer. this policy will probably reduce unemployment associated with demand deficiency. Is the following assertion true. It does not distinguish between unemployment of a skilled adult and unemployment of an unskilled new entrant into the labor force. The social desirability of raising unemployment insurance (UI) benefits depends on a number of factors. so that – despite its weaknesses – we can measure changes in labor market conditions from one year to the next." The unemployment rate is currently used as a major indicator of the relative strength of labor supply and demand. Therefore. Do you think the unemployment rate is a useful indicator of labor market tightness? Answer. Finally. the costs of higher UI benefits are the prolonged spells of unemployment they induce (they encourage unemployed workers to search longer). false. It provides no information about the number of individuals who are not actively searching for work because they were unsuccessful in the past. 6. It is consistently measured over time. it is sensitive to the generosity of some social programs. Answer. There are many problems with using the aggregate unemployment rate as an indicator of labor market tightness. Government officials find it useful to measure the nation's "economic health. a policy of raising UI benefit levels is not socially desirable. Policy number one clearly increases the incentives of firms to retain workers during a recession. From an efficiency perspective. and unemployment in the long run? Answer. If the training that is subsidized is useful and geared to market demands. If individuals find higherpaying jobs that match their skills more closely. What probable effects would these policies. Hence. 4. like the unemployment insurance system. and the required time in the average plant was two to three months. or uncertain? "Increasing the level of unemployment insurance benefits will prolong the average length of spells of unemployment. output will increase and the probability that these workers will quit their jobs in the future will decline.

reduce structural unemployment as well. That is, firms could train their workers to fill newly created jobs for which their current work force was not trained, or it could use the subsidy to provide training to its workers that other firms might find useful. This latter policy might be pursued by firms whose labor demand was shrinking and who might find it more profitable to induce employees to quit rather than undergo the expense of laying them off. Requiring advance notice of layoff to employees raises labor costs because firms are no longer free to lay off workers the instant marginal productivity slips below the wage rate. While the short-run effects of this may indeed inhibit layoffs, the longer-run effect is that the rehiring of labor when the market improves will be discouraged. That is, by raising the costs of labor, the firm will be induced to scale down its operations and to substitute capital for labor. The slowing down of the post-recession recall of laid-off workers and the possibility of reduced labor demand could cause unemployment to rise (or remain) higher than it otherwise would. Of course, this conclusion would change if wages were to fall when this new "fringe benefit" of advance notice was mandated. A requirement that laid-off workers be given first option on any new jobs with the former employer might prevent such employers from hiring younger, less experienced workers, and could cause the composition of unemployment to change. That is, the unemployment rate for older workers might fall and the unemployment rate among younger workers might be expected to rise as a result of this policy. By constraining firms to hire older, displaced workers from declining departments in their expanding departments, the requirement raises labor costs and will tend to cause employment growth to be smaller than it would otherwise be. This, of course, could contribute to unemployment in the long run. 8. The present value of benefits in many pension plans are larger if a person retires before the normal retirement age. In short, there is a large inducement for many private sector workers to retire early. What effect will increasing the inducements to retire early have on the unemployment rate of older men? Fully explain your answer, making use of the assumption that retired workers withdraw from the labor force and do not seek or obtain other jobs. Answer. It is possible that increased inducements for early retirement will increase the unemployment rates of older workers. The reason for this is that they may induce older workers who are currently employed to withdraw from the labor force earlier than they otherwise would, thereby increasing flows from employment to "out of the labor force." When flows from employment to out of the labor force are increased, other things equal, the unemployment rate will rise because there is a fall in the labor force without a corresponding fall in unemployment. It is possible, of course, that the older workers deciding to retire early are predominantly those who have just been laid off -- perhaps permanently -- by their employers. They may believe that, rather than continuing to search for work, they would be better-off accepting their pension and dropping out of the labor force. Obviously, the more


generous their pension is prior to normal age of retirement, the greater is the likelihood that they will drop out of the labor force after layoff. Thus, it is impossible to say whether more generous early retirement benefits tend to increase or reduce the unemployment rate of older men. Answers to Even-Numbered Problems 3. Suppose that initially the Pennsylvania economy is in equilibrium with no unemployment: Ls = -1,000,000 + 200W and Ld = 19,000,000 – 300W, where W = annual wages and L = number of workers. Then structural unemployment arises because the demand for labor falls in Pennsylvania but wages there are inflexible downward and no one moves out of state. If labor demand falls to Ld = 18,000,000 – 300W, how many workers will be unemployed in Pennsylvania? What will be its unemployment rate? Answer: Find the initial wage and employment level by solving as below: -1,000,000 + 200W = 19,000,000 – 300W, so 500w = 20,000,000, and W = $40,000 With W = $40,000, L = 7,000,000. Next, find the gap between Ls and Ld at W = $40,000 after the labor demand curve shifts: Ls = -1,000,000 + 200x40,000 = 7,000,000 Ld = 18,000,000 - 300*40,000 = 6,000,000 This gap, Ls - Ld, shows that unemployment equals 1,000,000. The unemployment rate is (1,000,000/7,000,000)x100 = 14.3%.

Suggested Essay Questions 1. “With the growth of free trade, Mexican employers have sought to reduce union control over internal labor markets, and they have eliminated promotion by seniority, rules against subcontracting, and restrictions on the use of temporary workers – all in the name of greater flexibility.” Would you expect greater employer flexibility in hiring and assigning workers to increase or decrease unemployment in Mexico? Explain. Answer. The level of unemployment in any country is a function of how fast workers flow into unemployment as compared to how fast they flow out. The above changes in Mexican employment conditions will probably tend to increase flows into unemployment, but by allowing employers to be more flexible, they lower the costs of creating new jobs. Hence, flows out of unemployment will tend to increase as the pace of job creation is enhanced. Even the flows into unemployment will be reduced, however, if the changes


permit labor costs to be more flexible in a downward direction during periods of falling demand. 2. One student of the labor market effects of free trade argues that the government should offer “wage insurance” to workers who lose jobs because of free trade. Under this proposal, the government would replace a substantial portion of lost earnings if, upon re-employment, eligible workers find that their new job pays less than the one they lost. This wage insurance would be available for up to two years after the initial date of job loss. Would this wage insurance program reduce unemployment? Answer. Wage insurance should cause unemployed workers to take offers they would normally have rejected, thus increasing the flows out of unemployment and into jobs – which, by itself, would reduce unemployment. Two factors might serve to increase the flows into unemployment, however, which could increase the level of unemployment. First, if workers take jobs hastily (the clock starts ticking upon job loss), they may be poorly matched with their employers – and may quit or be fired after the insurance runs out. Second, employers may be less reluctant to lay off workers, knowing that they have wage insurance for two years after layoff.


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