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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.
A NOTE TO THE INSTRUCTOR
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
Introduction Appendix 1A .OVERVIEW OF THE TEXT INTRODUCTION/REVIEW: Chapters 1 and 2 Chapter 1 .The Demand for Labor Appendix 3A .Graphic Derivation of a Firm's Labor Demand Curve Chapter 4 . Before analyzing the labor/leisure choice and household production.Statistical Testing of Labor Market Hypotheses Chapter 2 . however. are selfcontained. Finally.Labor Demand Elasticities Appendix 4A .Overview of the Labor Market Chapters 1 and 2 introduce basic concepts of labor economics. 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. and 5. Therefore. The concepts are used to analyze how technological change and foreign trade affect labor demand. we first introduce students to the employer side of the market. In Chapter 4 we move to a discussion of the elasticity of demand." If the course is being taught to economics majors with intermediate microeconomics as a prerequisite. We strongly recommend assigning Appendix 1A in courses requiring students to read empirical papers in the field. we note that Chapters 6 and 7. Chapter 5 analyzes the quasi-fixed nature of many labor costs and the ways these costs affect the demand for labor.International Trade and the Demand for Labor: Can HighWage Countries Compete? Chapter 5 . be used as building blocks when a professor must "begin at the beginning. For instructors who desire to cover topics concerned with the decision to work first. and analyze the determinants of the precise relationship between wages and employment.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. therefore. An appendix to Chapter 1 introduces the student to econometrics. nothing would be lost if Chapters 6 and 7 were taught ahead of Chapters 3. In Chapter 3 the principal question analyzed is why demand curves slope downward. and can. 1 . THE DEMAND FOR LABOR: Chapters 3-5 Chapter 3 . which deals with that decision. They are written to be accessible to students without backgrounds in intermediate theory. 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. 4. these chapters may be skipped or skimmed quickly as a review.
Chapter 7 could be skipped. The essential features of the decision to work for pay are included in Chapter 6. however.Worker Mobility: Migration.SUPPLY OF LABOR TO THE ECONOMY: Chapters 6 and 7 Chapter 6 .Unions and the Labor Market Appendix 13A . FACTORS AFFECTING THE CHOICE OF EMPLOYMENT: Chapters 8-10 Chapter 8 . Chapters 8 through 10 analyze these choices.Arbitration and the Bargaining Contract Zone 2 .Investments in Human Capital: Education and Training Appendix 9A . Chapters 9 and 10 analyze issues affecting worker investments in skill acquisition (Chapter 9) and job change (Chapter 10). Immigration. and Turnover Once they have decided to seek employment. Race. prospective workers encounter important choices concerning their occupation and industry. doing so would eliminate analyses of family labor supply decisions as well as labor supply decisions in the context of the life cycle.Compensating Wage Differentials and Labor Markets Appendix 8A . the Family. 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. More particularly.Supply of Labor to the Economy: The Decision to Work Chapter 7 .Estimating "Comparable Worth" Earnings Gaps: An Application of Regression Analysis Chapter 13 . and Ethnicity in the Labor Market Appendix 12A . As noted above. as well as the general location of their employment.Compensating Wage Differentials and Layoffs Chapter 9 . and the Life Cycle Chapters 6 and 7 analyze the decision of an individual to work for pay. In one-quarter courses or courses in which time is scarce. ANALYSES OF SPECIAL TOPICS IN LABOR ECONOMICS: Chapters 11-15 Chapter 11 .A "Cobweb” Model of Labor Market Adjustment Appendix 9B . The traditional analysis of the labor/leisure choice is given in Chapter 6.Labor Supply: Household Production. while in Chapter 7 the decision to work for pay is placed in the context of household production.Gender. Chapter 8 presents an analysis of job choice within the context of jobs that differ along nonpecuniary dimensions.A Hedonic Model of Earnings and Educational Level Chapter 10 . and both employ the concepts of human capital theory. 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. All three chapters contain appendices of interest to instructors who wish to teach more advanced material.Pay and Productivity Chapter 12 .
we now move to analyses of special topics: compensation.Unemployment Having presented basic concepts and analytical tools necessary to understand the demand and supply sides of the labor market. and unemployment. The chapters on unionism (Chapter 13) and discrimination (Chapter 12) deal with issues typically covered in labor economics courses.Chapter 14 . 3 .Lorenz Curves and Gini Coefficients Chapter 15 . A complete analysis of all these topics requires an understanding of behavior on both the demand and supply sides of the market. It should be noted that the appendix to Chapter 12 includes an application of regression analysis. however.Inequality in Earnings Appendix 14A . discrimination. unions. No new analytical tools are introduced in these chapters. The chapter on inequality is unique and can be skipped without a loss in coverage of conventional material. it is written in a way that provides a review of material in previous chapters. and these chapters are built upon the preceding ten. but they are more comprehensive than most other texts. inequality.
The basic purpose of Chapter 1 is to introduce students to the two major modes of economic analysis: positive and normative. 4. A governmental policy is "Pareto-improving" if it encourages additional mutually beneficial transactions. The analysis then moves to multivariate analysis and the problem of omitted variables. At times. government 4 . the exchange of information. in addition. 2. Chapter 1 discusses the bases of each mode in some detail. though. as is the underlying concept of scarcity. In our treatment of positive economics. students must understand the ways economic analyses are used. Normative economics is the study of what "should be. 6.INTRODUCTION Because the textbook stresses economic analysis as it applies to the labor market. the goal of improving Pareto efficiency conflicts with one of generating more equity. 7. and there are three common reasons for such failure. The concept that governmental intervention in a market may be justified on grounds other than the principle of mutual benefit is discussed (for example. and the execution of contracts. explaining the concepts of dependent and independent variables. 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. the "intercept" and "slope" parameters. the "error term. " 5. List of Major Concepts 1. the concept of rationality is defined and discussed. The essential features of a market include the facilitation of contact between buyers and sellers." and theories of social optimality are based in part on the underlying philosophical principle of "mutual benefit. The appendix to Chapter 1 introduces the student to ordinary least squares regression analysis. Labor market examples of governmental remedies are provided. Because both modes of analysis rest on some very fundamental assumptions.CHAPTER 1 . 3. It begins with univariate analysis. The uniqueness of labor services affects the characteristics of the labor market. and underlying this theory of behavior are the basic assumptions of scarcity and rationality. introduced in a graphical context. Positive economics is the study of economic behavior. There is. A market "fails" when it does not permit all mutually beneficial trades to take place." and the t statistic. and an example of the behavioral predictions flowing from such a model is presented. a lengthy discussion of what an economic model is.
e. 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. Answers to Even-Numbered Review Questions 2. holding the other variables constant. appearance) without getting into the complexities of 5 .intervention may be justified on the grounds that income redistribution is a desirable social objective). and in designing such a building the architect may employ a model that captures the essentials of his or her concerns (namely.a procedure that plots the "best" line (the one that minimizes the sum of squared deviations) through the various data points. c. The military draft compels people to engage in a transaction they would not voluntarily enter into. In this sense an economic model is analogous to an architect's model of a building. (Appendix) If an independent variable that should be in an estimating equation is left out. 10. If further immigration of unskilled foreigners is prevented.g. wages and quit rates) can be plotted graphically. and the uncertainty surrounding these estimates are summarized by the standard error of the estimate. (Appendix) A way to summarize a linear relationship between two variables is through ordinary least squares regression analysis -. An architect may be interested in designing a building that fits in harmoniously with its surroundings. (Appendix) Multivariate procedures for summarizing the relationship between a dependent and two or more independent variables is a generalization of the univariate procedure. Employers should not be required to offer pensions to their employees. The parameters describing this line are estimated. this visual relationship can also be summarized algebraically. (Appendix) The relationship between two economic variables (e. it should therefore be avoided as a way of recruiting military personnel. 9. Are the following statements "positive" or "normative"? Why? a. If the military draft were reinstituted. b. military salaries would probably fall. Answer: (a) normative (b) positive (c) positive (d) normative (e) positive 4. 8.. estimates of the other coefficients may be biased away from their true values. Employers offering pension benefits will pay lower wages than they would if they did not offer a pension program. 11. and each coefficient can be interpreted as the effect on the dependent variable of a one-unit change in the relevant independent variable. the wages of unskilled immigrants already here will rise.
“Government policies as frequently prevent Pareto efficiency as they enhance it. 8.. 6. There were women who wanted to work more than 40 hours a week. A few years ago it was common for state laws to prohibit women from working more than 40 hours a week.01x20x20 = 3 + 6 . How much is a 20-year-old predicted to earn based on the second estimate? Answer: a. our model may not correctly forecast the observed behavior if stimuli C through E also change. both of which can prevent the completion of mutually beneficial transactions.3Ai . Answer. (Appendix) Suppose that a least squares regression yields the following estimate: Wi = -1 + . Similarly..” Comment. 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. where W is the hourly wage rate (in dollars) and A is the age in years. mandating premiums for overtime work. evaluate these laws. and E held constant. However.01(Ai)2. electrical circuits. governments also have power to prevent transactions or distort prices. Government also has the power to distort prices by setting minimum wages. 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). Answers to Even-Numbered Problems 2. and there were employers who wanted to employ them for more than 40 hours a week.3x20 . b. if we are interested in bow behavior is affected by stimulus B. 6 .3Ai. The restrictions upon their employment prevented these transactions from occurring and therefore made both the women and their potential employers worse off.plumbing. Answer: Laws preventing women from working more than 40 hours per week essentially blocked mutually beneficial transactions. W = -1 + .4 = 5 dollars per hour. a. with factors C. and the design of interior office space. and so forth. How much is a 20-year-old predicted to earn based on the first estimate? b. W = 3 + . Achieving Pareto efficiency requires the completion of all mutually beneficial transactions. Using the principles underlying normative economics. For example. 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. Ideally. A second regression from another group of workers yields this estimate: Wi = 3 + . Models used to generate insights about responses to a given economic stimulus are often not intended to forecast actual outcomes.3x20 = 5 dollars per hour. D.
A law preventing such work prevents a mutually beneficial transaction. Answer. A law in one town of a Canadian province limits large supermarkets to just four employees on Sundays. and there are no doubt employees who could be induced – perhaps by higher wages – to work on Sundays. From the perspective of normative economics. There are no doubt large supermarkets that want to hire workers on Sundays (because there are consumers who want to shop on Sundays).Suggested Essay Questions 1. Child labor is an issue that has been discussed a lot recently. Analyze this law using the concepts of normative economics. and they have limited capacities to make informed decisions even in the absence of compulsion. Children may be compelled by their parents to work. 2. 7 . and this can be assured only if the transactions are voluntary and take place with complete information. explain the problem with child labor. Answer: Pareto efficiency requires that transactions have mutual benefits.
and it is the purpose of Chapter 2 to provide that framework. internal. magnitudes. unemployment. Changes in the industrial and occupational distribution of employment are facilitated by the labor market. local. we discuss basic concepts of demand and supply so that students will be able to see their interaction at the very outset. Particular attention is given to the distinction between movement along a curve and shifts of a curve. A similar discussion and set of distinctions are made for the supply side of the market. After both the demand and supply sides of the market have been discussed and generally modeled. which also facilitates adjustments to the "birth" and "death" of job opportunities. definitions. the existence of disequilibrium. and the concept of being "overpaid" or "underpaid" (including a discussion of economic rents). the distribution of employment. external. We start the overview with a discussion of demand schedules and their corresponding demand curves. Forces that can alter market equilibria are comprehensively discussed. 8 . the chapter discusses and presents data on such topics as the labor force. 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). To this end. and the chapter's major concepts are reinforced by discussions of the effects of unions. This chapter has both a descriptive and an analytical purpose. secondary) are defined. The distinction between nominal and real wage rates is made. and the level of (and trends in) labor earnings. List of Major Concepts 1. 4. and major trends in labor force participation rates are discussed. trends in the unemployment rate are noted. regional. 2. The "labor force" consists of those who are employed or who are seeking work. and trends of widely used labor market descriptors. The second aim is to provide students with an overview of labor market analysis.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.CHAPTER 2 . primary. To this purpose. 3. It is our belief that students learn most efficiently if they can associate these new ideas with an overall framework. 5. The chapter ends with a discussion of unemployment across various countries. The labor market and its various subclassifications (national. Distinctions between individual and more aggregated demand curves are discussed. One aim is to introduce students to the essential concepts. we turn to the question of wage determination and wage equilibrium. and the calculation of real wages is illustrated.
The concepts of shortage and surplus are directly related to the relationship between actual and equilibrium wage rates. Changes in the equilibrium wage rate are caused by shifts in either the demand or supply curves.) An increase in product demand. and income are depicted graphically. The interaction of market demand and supply determines the equilibrium wage. Unemployment rates. 8. 15. Distinctions among wage rates." 16. 9 . 7. have risen in Europe relative to the United States and Canada over the recent decade. earnings. in turn. and the supply schedule of competing factors of production. and especially long-term unemployment rates. Disequilibium will persist if the wage is not allowed to adjust to shifts in demand or supply. 9. rather than shifts of. 12.) A fall in the danger of the occupation. the choice of technology. The concepts underlying a labor demand schedule are associated with product demand. Analyze the impact of the following changes on wages and employment in a given occupation: a. scale and substitution effects are ultimately related to these forces. labor market outcomes (terms of employment and employment levels) are affected by both product and capital markets. 14. the curves tend to shift. this rise may reflect the existence of relatively stronger nonmarket forces in Europe. 13. when a variable not shown on the graph changes. Individuals paid more than their reservation wage are said to obtain an "economic rent. 11. 17. b. 10. total compensation. demand and supply curves occur when wages of the job in question change. Movements along.6. Underlying a supply schedule for labor are the alternatives workers have and their preferences regarding the job's characteristics. Answers to Even-Numbered Review Questions 2. Distinctions between individual and market demand and supply curves are discussed. The labor market is one of three major markets with which an employer must deal. The concepts of "overpaid" and "underpaid" compare the actual wage to the equilibrium (market) wage rate.
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. the prices that will be charged to consumers will rise. Thus. This device does not increase the efficiency with which the lawnmower operates. What could happen to cause the equilibrium wage to fall? If all money wages rose each year. 6. This price increase will move the firm upward and to the left along its product demand curve. Answer: This regulation would cause the demand for labor curve of the firms that manufacture power mowers to shift to the left. 8. While market wages are usually stated in nominal terms. Suppose a particular labor market were in market-clearing equilibrium. (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. The demand for labor is in part derived from product demand. the supply curve to the given occupation will shift left and tend to drive up wages. in the last analysis. What. With less product demanded for any given wage rate paid to workers. both parties to the employment relationship are. Because it is more costly now to manufacture lawnmowers. other things being equal. does this regulation do to the demand for labor of firms manufacturing power lawnmowers? Explain. their relationship to the prices of both consumer and producer products is of ultimate importance.c. Answer: (a) A fall in the danger of the occupation. how would this market adjust? Answer: Starting from the position of equilibrium. 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). and the army's wages will be driven up.) Increased wages in alternative occupations. should increase the attractiveness of that occupation. (b) An increase in product demand will shift the demand for labor curve to the right causing both wages and employment to increase. 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. 4. The real wage rate can fall when the nominal wage rate is rising if prices of consumer and producer products rise even more quickly. Therefore. shifting the supply curve to the right and causing employment to rise and wages to fall. This will cause employment in this market to fall and wages to rise. the end result is a leftward shift of the labor demand 10 . Suppose that the Consumer Product Safety Commission issues a regulation requiring an expensive safety device to be attached to all power lawnmowers. if anything. If those opportunities become more attractive. concerned with the real wage rate.
employers desire 25. a. However. employment losses would be mitigated. b. This decline in employment is larger than the ultimate decline in employment. Now suppose that at any given wage 20. if W = 400. 11 . See the figure.) 10. drawing a line using these two points gives us the demand curve. What are the equilibrium wage and employment level in this market? c. is it likely that employment in the region will recover? Explain. however.000 more workers are willing to work as school teachers. If W = 500. if supply curves are upward-sloping. the declining wage will cause some withdrawal of labor from the market and employment will not recover to its prior level. (If. Plot the demand and supply curves. Why doesn't employment grow by 20. for example. 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.curve. where L = the number of teachers and W = the daily wage.000 workers (Ld = 100. Answers to Even-Numbered Problems 2.000 – 150W. Plot the new supply curve and find the new wage and employment level. 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.000? Answer: a.000 – 150x500).000. consumer preferences for greater safety were to shift the product demand curve to the right. and (ii) wages that are fixed in the short run. Use the same procedure for the labor supply curve. they would desire 40. If the new demand for labor curve remains unchanged for a long period and the region's labor supply curve does not shift. 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. Plot the Ld and Ls curves by solving for desired employment at given wage rates. Since the equation above is for a straight line. Suppose that the supply curve for school teachers is Ls = 20. 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 + 350W and the demand curve for school teachers is Ld = 100.
Assume this movement takes the form of boycotting items made under sweatshop conditions. which induces some teachers to drop out of the market.000 because the shift in the supply curve causes the wage to fall.000 + 350W = 100.b.000. solve for the wage at which the quantity of labor supplied equals the quantity of labor demanded: Ls = 20. To find the equilibrium. Plugging W = $160 into both the labor demand and supply equations shows that L = 76. c.000 from both sides to yield 500W = 80.000 + 350W. Suggested Essay Questions 1.000 schoolteachers. Employment doesn't grow by 20. Solve for W by adding 150W to both sides and subtracting 20.000 – 150W = Ld. The new labor supply curve is Ls' = 40. Dividing both sides by 500 reveals that W = $160 per day. 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).000 school teachers. L = 82. 12 . Setting this equal to Ld and solving shows that W = $120 per day.
(b) Assuming that actions by American students are the only force driving the improvement of wages and working conditions in foreign countries. Outlawing child labor on banana plantations reduces the supply of labor to these plantations. which are grown and harvested by a large labor force that includes many children. Answer. (b) To avoid the effects in (a). Assume Ecuador now outlaws the use of child labor on banana plantations. This drives down wages and employment (assuming a fixed supply curve). 2. analyze what would happen to employment and wages in the banana farming industry in Ecuador. Ecuador is the world’s leading exporter of bananas. what must these actions include to ensure that the workers they are unambiguously better off? Answer. they must be willing to pay a premium for apparel made by betterpaid workers. With a fixed demand curve. students in the U. Using economic theory in its “positive” mode.(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. this shift in the supply curve drives up wages and drives down employment. must be willing to buy the same quantity and quality of apparel at higher prices – that is.S. (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. shifting the supply curve to the left. Use demand and supply curves in your analysis. 13 .
holding capital constant. and then move to an analysis of demand when the labor market is monopsonized.THE DEMAND FOR LABOR This chapter studies the downward sloping nature of the labor demand curve. and they are also discussed verbally. The process of profit maximization requires considering small changes in inputs (or outputs). The difference between the short-run and long-run depends on the fixity of capital. The principal conceptual tool employed involves distinguishing between the wage rate employers pay and the wages employees receive. 14 . These conditions are expressed in simple mathematical terms. 2. in this context. 3. We derive the demand for labor graphically using a two-factor model in both the long-run and short-run. Next we consider the demand for labor when the product market is not competitive. we first consider the short-run before moving on to the long-run and the case with more than two inputs. The appendix to Chapter 3 is designed for students who feel comfortable using microeconomic theory at the intermediate level. Additional insights into the marginal productivity theory of demand are provided in a section discussing common objections to this theory of demand.CHAPTER 3 . When these two wages differ. The marginal product of labor is the added output generated by adding a unit of labor. Both substitution and scale effects are graphically illustrated. one must be stated in terms of the other for the demand and supply curves to be shown together. List of Major Concepts 1. firms perceive prices as given. one of the two curves must therefore shift. and it moves deductively from the assumption of profit maximization to the marginal conditions with respect to labor. The assumption of profit maximization by firms underlies the theory of labor demand. and there will be related changes in both wages and employment. If markets are competitive. 4. It begins with a section that discusses profit maximization. and the assumptions underlying the demand curve are more rigorously presented. 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. In the latter context. and comparing the marginal revenue generated by an additional input with its marginal expense. 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. we contrast the wage and employment effects of "market" and "mandated" shifts in the labor supply curve. The analysis of demand begins with the assumption that both labor and product markets are competitive. When a payroll tax is introduced.
the demand for one grade of labor is influenced by the wages of other grades of labor. and gross complements are defined and related. 10. flatten the labor supply curve and reduce the marginal expense of labor. The conditions for profit maximization with respect to capital are relevant in the longrun. The concept of diminishing marginal productivity is discussed. The concepts of substitutes in production. The relationship between the demand for labor curve and the downward sloping portion of a firm's marginal product of labor curve is analyzed. and thus. the demand for labor. employment. 11. 16. complements in production. 15. Product market monopoly affects the profit maximization conditions. 8. In the context of monopsony. 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. 12. 17. (Appendix) The graphical depiction of a production function is presented. and the labor conditions for profit maximization. 18. Generalizing to more than two inputs. The demand for labor can be stated in terms of either the real or the nominal wage. 14. The relationship between the demand curve of individual firms and the market demand curve is briefly discussed. 7. and the resultant increase in the marginal expense of labor above the wage rate. gross substitutes. Monopsony in the labor market affects wages. 15 . 6. causing worker wages and/or employment levels to fall. wage increases accompanying market shifts (to the left) in the labor supply curve produce the conventional expectations of decreased employment. (Appendix) The demand for labor in the short-run is graphically derived. Two principal objections to the marginal productivity theory of labor demand are presented and discussed. The reason for this derives from the upper-sloping labor supply curve facing the individual firm. at least in the short-run. however.5. 13. and adjustments of capital to changes in relative prices generate substitution effects on employment. Mandated wage increases. leading to ambiguous expectations regarding employment changes. 9.
D0. Answer. Thus. 6. it will lose less civilian output than it would by drafting an equal number of civilian workers randomly. When inmates were required to work without pay. showing both substitution and scale effects of a wage change. Answer. 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. military is having difficulty recruiting volunteers and is considering one of two options: raising pay or reinstating the draft system. Given the demand curve. pay is an important consideration. and that the cleaning and food preparation tasks are now performed by non-prisoners hired to do them. Now suppose that prisoners are offered paid work in factory jobs within the prison walls.19. the cost of expanding output using labor becomes greater. there is also an opportunity cost to society of lost worker utility!) 4. we can assume that those with higher pay also have higher civilian MRPL. Suppose that the U. 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. S0. Answers to Even-Numbered Review Questions 2. If some of the latter are forced into the military. Conversely.) 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. Because profits are maximized when workers’ marginal revenue productivities (MRPL) are equal to the wage (W). (It should be noted that pay is not the only consideration in choosing a job. In choosing employers. 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. when society relies on military volunteers. is graphically illustrated. and the supply curve. many of those who choose a military job are those whose civilian job opportunities pay less than the military. Thus. 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. Those who choose civilian life over the military will be those who would get the least utility from performing military duties. market clearing wage and employment levels will be W0 and E0.8c). (Appendix) The demand for labor in the long-run. their wage was essentially zero – and we would expect that prisons to have adopted labor-intensive technologies (using the argument inherent in equation 3. in the absence of any subsidy. respectively. and we expect prisons to adopt the use of more capital in the production process. without pay.S. Suppose that prisons historically have required inmates to perform. and that workers are really trying to maximize utility. 16 . many of those who choose to remain civilians are workers whose civilian pay is higher than their military pay offer. is assumed to be equal to the wage paid by employers). When wages rise.
the supply of female labor would now exceed the demand. Indeed. explain why a growing firm with facilities in both Mexico and the U. the more responsive labor supply is to the wage rate.20. E2. might still expand its output using U. This equilibrium occurs at the wage rate W1. as long as labor supply is responsive to wages).) 17 . Since the wage paid by employers now equals the wage women receive less the 50-cent subsidy. At the old wage paid by employers. workers. As a result. At the old market clearing wage received by women. and this wage rises until the excess demand for labor is eliminated. exceeds the number who are willing to work. and the employment level E1.Suppose the government now subsidizes employers by paying them 50 cents for every hour women work. manufacturing worker were $19.12.S. (Hint: consider U. and Mexican workers to be substitute factors of production. 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. the wage received by women would rise by 50 cents less the fall in the wage paid by employers. 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. W0.. E0. the less the women's wage will rise. the U. Recognizing that the analysis leading up to equation 3. the employers' demand curve will shift up by exactly 50 cents (reflecting the fact that this amount will be paid by the government).S. Viewed in terms of the wage received by women. This puts upward pressure on the wage received by women. If supply and demand curves are drawn in terms of this variable.8c can be used to understand the choices firms make between any two factors of production. 8. Bureau of Labor Statistics reported that hourly compensation costs per U. the number of women employers want to hire. while those in Mexico were $2. 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).S. In 1999.S. it is also clear that the wage paid by employers declines (by 50 cents minus the increase in the wage women receive).e. a 50-cent-an-hour subsidy for women would shift the female labor supply curve down by 50 cents.S.
50x400 = $200 18 .50x3200 = $1600 $. profit maximization means that firms will substitute one for another until the ratio of their wages to their marginal productivities are equal. and needs to decide how many supervisors to hire. workers.50 each. In choosing between U. and Mexican workers. where L = the number of workers. but if the relative marginal productivity of Mexican workers is even lower. If the wage of saw mill workers is $10 per hour.S. The firm needs to compare the marginal cost to the marginal revenue of hiring an additional supervisor.Answer. then how many workers will the mill hire? Answer: The mill will hire workers until MRPL = W.. The marginal revenue product of labor in the local saw mill is MRPL = 20 .50x700 = $350 $.50x3800 = $1900 $.000 14. Put differently. To do so.500 20.600 Answer.800 18. Number of Supervisors 1 2 3 4 5 MC $500 $500 $500 $500 $500 MR $. Answers to Even-Numbered Problems 2.S.5L = 10 when L = 20 4. The output of workers at a factory depends on the number of supervisors hired (see below).S. as shown below. firms would decide to expand output using U. The daily wage of supervisors is $500 but output rises as more supervisors are hired. even though wages are lower in Mexico.200 20. The factory sells its output for $. workers.8c). it hires 50 production workers at a wage of $100 per day. How many supervisors should it hire? Supervisors 0 1 2 3 4 5 Output (units per day) 11.. 20 .S. 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. The marginal cost is always $500 for each extra supervisor. the ratio of wages to marginal productivity – which is the critical datum – could be higher there than in the U. Mexican wages may be much lower than in the U.000 19. The marginal revenue is the number of additional units produced times the price of output..5L.50x1500 = $750 $. The profit-maximizing firm will choose to expand production in the least costly way.
“Despite free trade and the need to compete with American and Canadian manufacturers. does this indicate that. If this movement is successful in raising pay and improving working conditions for apparel workers in foreign countries. most Mexican factories continue to use outdated equipment and inefficient (labor-using) work systems. other things equal. Answer. Does this mean that keyboarding jobs in the United States will be lost to India? Explain. Thus. including the United States). 2. how will these changes abroad affect labor market outcomes for workers in the apparel and retailing industries in the United States? Explain. 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). Assume that wages for keyboarders (data entry clerks) are lower in India than in the United States. When wages are low and capital is costly. then there will be incentives to substitute for these foreign workers (with capital or workers elsewhere. marginal productivity is also critical. 19 .” If true. it is not wage alone that affects the incentives to substitute. economic theory leads us to expect that firms would use labor-intensive methods to produce. which will put downward pressure on employment in the American apparel and retailing industries. Indian data entry clerks will be substituted for American ones only if the ratio of their wage to their marginal productivity is lower. increased costs of manufacturing university apparel also would be expected to reduce sales and the scale of output.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. However. 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. plant owners there are making mistakes? Answer. If increased labor costs abroad are not accompanied by increases in marginal productivity. 3. 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). Suggested Essay Questions 1. Answer. in the face of very low wages in Mexico.
that other things influencing employment levels be controlled for. 4. 3. List of Major Concepts 1. We begin the chapter by defining and discussing the own-wage elasticity of demand. Cross-wage elasticities of demand are the percentage change in employment of a class of labor induced by wage changes in another class. 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).CHAPTER 4 . 6. Actually measuring the employment effects of minimum-wage increases requires that we distinguish between nominal and real changes in the rate. The concepts of gross substitutability and gross complementarity are defined and distinguished from substitutability or complementarity in production. The four Hicks-Marshall laws of derived demand are introduced and related to the substitution and scale effects of a wage change. 20 . and that the presence of uncovered sectors and intersectoral shifts in product demand be built into the design of the study. The chapter concludes with sections that apply the concepts of demand elasticity to analyzing the effects of minimum-wage legislation and technological change. Chapter 4 deals with the magnitude of the employment response to a change in the wage rate. 2. we move to a discussion of the cross-wage elasticity of demand. Empirical evidence concerning the own-wage and cross-wage elasticities of demand. Another section is devoted to a discussion of the empirical evidence on both the own-wage elasticity of demand and cross-wage elasticities. The appendix to Chapter 4 analyzes the labor-market effects of international trade.LABOR DEMAND ELASTICITIES While Chapter 3 dealt with the downward sloping nature of labor demand curves. 5. with each of the four laws being related to the substitution and scale effects (concepts that were introduced in Chapters 2 and 3). they may be positive or negative. is presented. In this regard the Hicks-Marshall laws of derived demand are explained. based on both statistical studies and inferential analyses. After discussing the laws of derived demand in the context of own-wage effects. 7. 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.
In contrast. Which union faces the more elastic demand curve? b. 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 to $4. The labor-demand effects of technological improvements in capital depend on crosselasticities. Even those studies with negative employment effects generally find labor demand elasticities that are much smaller than those summarized earlier in the chapter.00. 12. when one decreases union A's wage from $5.000 person hours.00)/4.00-4. Technological change in product markets can change the slope and placement of product demand curves. Technological change causes total employment to be reallocated. Indeed. the actual value of the elasticity depends on the wage rate from which one is starting. its elasticity is given by (10.000)/20.00-5. Union A faces a demand curve in which a wage of $4 per hour leads to demand for 20. it is not true that trade will cause permanent job loss in high-wage countries.00 or (-1)/(1/5) or -5.000 person hours. Given the data on union A and the formula for the elasticity of demand.000-20. while a wage of $5 per hour leads to demand for 33. union A's elasticity when one increases its wage rate from $4.000 person hours and a wage of $5 per hour leads to demand for 10. 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). the elasticity of demand for labor is not necessarily a constant along a given demand curve.00 is given by (20. when we speak of changes in wage rates that are not infinitesimal. The results of studies estimating the effects of minimum-wage increases are sensitive to the specification employed.000 divided by ($4. and while trade may shift employment across industries. which equals -2. 21 .000 divided by (5. Answers to Even-Numbered Review Questions 2. Union B faces a demand curve in which a wage of $6 per hour leads to demand for 30. in attempting to analyze the likely dominance of the substitution or scale effect in this case. with some studies finding the "conventional" negative effects and some finding none. Its elasticity over the interval $4. a. or (1/2)/(-1/4).000-10.00)/5. 9.000)/10. %E/%W.000 person hours. 11. 10.00.00 depends on which wage we use as a base. not permanently reduced. thereby shifting and/or changing the elasticity of labor demand curves.00 to $5. It is possible that the generally small effects of minimum-wage increases are the result of the studies' focus on short-run effects. the Hicks-Marshall laws applicable to own-wage changes cannot be slavishly applied.00 to $5.8. 13. (Appendix) International trade is based on comparative advantage.
there is also a scale effect tending to increase employment for the above categories.000]/[(4. tending to shift the labor demand curve to the left for categories of labor that are substitutes in production with capital.) Therefore. Note that this elasticity estimate does not vary with the end of the wage interval (high or low) at which one starts.50] = (2/3)/(-2/9) = -3 Elas.524 Given the above data.To prevent this type of result. the scale effect may prevail for many of these jobs (a dominant scale effect is more likely if product demand is elastic. if it is difficult to substitute capital for labor. (This answer assumes that wage/employment contracts under collective bargaining lie on the demand-for-labor curve.5(E1. (A): [(20.+W2)]. (b) One cannot say which union will be more successful in increasing its members' total earnings. 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. (B): [(33. and this is likely to reduce its incentive to push for large wage gains.000)/31. In the present question the average elasticities for union A and union B are given by Elas. economists often define the average elasticity over the wage interval W1. the labor demand curve clearly shifts to the right. This depends upon a number of factors.00)/4. Thus. including the bargaining power of the two unions and the firms with which they deal. however. 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.500]/[(5. However.000-30.)/.)/.over 15 percent in recent years. this need not always be the case. union A faces the more elastic demand curve. to W2 as [(E2-E1.000-10.00-5.00)/5.S.+E2)]/[(W2-W1. As shown in the appendix to Chapter 12.50] = -. that the union with the more elastic demand curve will suffer a larger percentage employment loss for any given percentage increase in wages.) 4. This causes a substitution effect.5(W1.000)/15. work force -.00-6. It is true. 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. (For labor categories that are complementary with capital in the production process. Clerical workers represent a substantial share of the U. so we cannot tell in advance which effect will dominate. 22 . and if the share of capital in total cost is large).
Just as the greater ability to substitute capital for labor will tend to make the labor demand curve more elastic. and the own-wage elasticity of demand for labor is 23 . In 1942 the government promulgated regulations that prohibited the manufacture of many types of garments by workers who did the sewing. stitching. and c) the size of civilian employment in comparison to this flood from the military. Besides the shift to the left of the labor demand curve. average wages in the civilian labor market would fall dramatically. draw a simple diagram depicting the effect of this influx of workers from the military. In this case Ld = 1 million. you will probably not concur with Professor Pessimist. 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. However. Assuming that the 1942 regulations were constraining. the new substitution possibilities opened up by repealing the 1942 regulations should serve to make the labor demand curve for factory workers more elastic.Even if labor demand shifts left for a particular occupational category. so that clothing items may now be made either by workers in factories or by independent contractors doing work in their homes. this substitution will tend to shift the labor demand curve for factory workers to the left. 6. If these prohibitions are repealed. Because you were asked about the effects on civilian wages as a whole. b) the magnitude of this elasticity for the economy as a whole. there may be a favorable scale effect for certain factory workers performing tasks (such as packaging and shipping) complementary with home production. and knitting in their homes. Own-wage elasticity of demand for labor = %(quantity demanded)/%(wage) = (Ld/Ld)/(W/W). using your knowledge of a) the definition of the own-wage elasticity of labor demand. graph these events and estimate the magnitude of the reduction in wages for civilian workers as a whole. First. Professor Pessimist argues before Congress that reducing the size of the military will have grave consequences for the typical American worker. but only if wages are rigid and employees refuse to shift to lower paying jobs will their unemployment be permanent. Next. unemployment will not be the long-term result unless wages are rigid. so too will the ability to substitute home labor for factory workers. Do you concur with Professor Pessimist? Answer. Assume that the demand curve for civilian labor does not shift when workers are released from the military. Adversely affected workers would have to shift to other occupations and may experience some transitional joblessness. 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. one can presume that there will be at least some substitution of home workers for factory workers.
2. Thus. and a scale effect that tends to reduce employment. What conditions would minimize the extent of manufacturing job loss associated with this price increase? Answer. and it really raises the cost of labor (trucks now require both a driver and monitoring equipment). Where it is easier to substitute capital for labor. the military recruits in a very narrow segment of the labor market-mostly high school grads who do not attend college. so neither has a comparative advantage in either good. This implies that wages will fall by 0. -1 = (1 million/135 million)/(W/W). Suggested Essay Questions 1. noting especially the conditions under which this effect is likely to be largest.approximately -1. and the other is to install devices that automatically shut down any truck that has been hijacked or deviates from its approved route. and if the demand for the products made using natural gas is relatively inelastic. then trucks will tend to get bigger and the number of drivers 24 . 4. Which good will the United States export to France? Answer: Neither. A small scale effect would be created if natural gas is a small part of the overall cost of production. However. and who are between ages 17-21. A large substitution effect will tend to occur if labor is easily substituted for natural gas in the production process. Factors that minimize the extent of job loss are those that make for a robust substitution effect and a small scale effect. This proposal is an attempt to monitor truck drivers. Thus. so W/W will be very small -. and if the supply of labor is relatively elastic.74 percent. If there were only 13. (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. One is to maintain continuous satellite monitoring of all such shipments. This question involves the cross-elasticity of demand. Answer. The two countries have the same opportunity cost. the four factors underlying the elasticity of labor demand are relevant. in this age group. downsizing would have the greatest effect on this segment of the market. 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).about -1/135 (or -0. One anti-terrorism expert proposes the development of two capabilities that would protect shipments of hazardous materials by truck. say.4% on this group of the population. a labor demand elasticity of –1 would yield a wage effect of the military downsizing of closer to –7.5 million.0074). 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. A higher price of natural gas will have a substitution effect that could favor increased employment. Discuss how implementing this proposal is likely to affect the demand for truck drivers. Thus.
the assumed facts in the question are quite consistent with economic theory. The substitution effect will also be larger if the supply of capital (in the form of larger trucks) is elastic. Finally. Assuming the facts on job loss and employment gains are accurate. become less efficient in the production of agricultural goods. If product demand is more elastic. the scale effect will be larger and product demand will go down more. Free trade allows countries to specialize in producing goods and services that have the lowest internal opportunity cost (that is. If we think of two generalized goods (agricultural goods and manufactured goods). to specialize in goods for which they have a comparative advantage).needed will go down more. jobs in Mexican agriculture have been destroyed while jobs in the industrialized cities of northern Mexico have expanded. If Mexico has a comparative advantage in the production of manufactured goods. are they consistent with economic theory? Answer. where the monitoring equipment represents a larger share of overall cost. by the definition of opportunity cost. One observer of the North American Free Trade Agreement (NAFTA) claims that. it must have a comparative disadvantage in the production of agricultural goods. contrary to expectations. a country becomes more efficient in the production of manufactured goods will. 3. Thus. (Appendix). the scale effect will be larger. 25 .
An investment is a type of expenditure that occurs primarily in some initial period and then does not recur. the section on hiring investments includes a discussion of credentials and signaling. 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). In the section on training investments the student is introduced to the notion of general and specific training. 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. we wanted to maintain the organizational overview in the minds of the students. because the quasi-fixed costs of labor are generally nonwage in nature. 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. it is our belief that this introduction to human capital theory in Chapter 5 is useful.CHAPTER 5 . and we also introduce the concept of hiring and training costs. In this section we discuss employee benefits (not all of which are quasi-fixed in nature). While the firm hopes to recoup the investment over a period it expects the worker to be with the firm. These topics are also discussed elsewhere in the text (notably in Chapters 11 and 12). Again. We begin the chapter with a descriptive section on the magnitude and growth of nonwage labor costs. In this chapter. This trade-off is discussed in the second section of the chapter.) 26 . The fourth and fifth sections offer detailed analyses of the two principal types of labor investments: training investments and hiring investments. the cost of investment becomes a "sunk cost.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. as well as an introduction to the concept of internal labor markets. In this particular case." 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). as well as to the implications of training investments for the demand for labor. the student is better able to learn the insights that economics has to offer. 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. 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. For similar reasons. because by maintaining a clear view of the overall context of analysis. we introduce particular concepts or tools as they are called for by the larger context of analysis. as throughout the text. 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.
7. Like training costs. The distinction between variable and quasi-fixed labor costs is made.List of Major Concepts 1. 12. 4. and the effects of specific training on the relationship between wages and marginal productivity is analyzed. The presence of hiring costs induces firms to use credentials and internal labor markets in the recruiting. and they are recouped by paying wages less than productivity. There are both explicit and implicit costs of job training. 27 . 8. and the way investment costs alter profitmaximizing conditions with respect to labor are all generalizations of the singleperiod analysis in Chapter 3. but whether they increase the number of workers employed depends on the size of the reduction in total labor hours demanded. 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. selection and promotion processes. 2. 9. The concept of present value and the need for discounting when economic decisions are made in the context of several time periods are discussed. 11. 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. 6. 3. the way this demand is affected by investment costs in the initial period of hire. the principal types of labor investments that firms undertake relate to training and hiring. 10. 13. hiring investments increase the productivity of selected job applicants (by distinguishing among them on the basis of productivity). and the firm must determine its optimum mix of employment and hours per worker. 5. 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. Employee benefits are categorized and the types typically received are listed. The presence of quasi-fixed costs causes an employment/hours trade-off. The distinction between general and specific training is defined.
as they are in industry X. helping them find other jobs. and that firms in the industry now have a greater probability of closing than they used to have. In the long run (that is. when the company is deciding about investing in new workers). When they are increased. In the short run (that is. but that developments in the product market quickly (and permanently) reduce marginal productivity by $2 per hour. so it is advantageous for the company to continue employing workers it has already trained. the firm will not hire and train new workers under the current circumstances. how will its employment level be affected in the short-run? How will its employment level be affected in the long run? Explain. Workers in a certain job are trained by the company. so all that is variable is the employment levels of trained workers). The company is not making back enough to make the training be a good investment. If the company does not feel it can lower wages or employee benefits. marginal revenue product still exceeds wages by $3 per hour. and (b) their average hours of work? Answer. but making back $3 per hour is better than laying off the workers and making back nothing! Thus. Suppose that the United States adopts a policy requiring employers to offer 600 hours of paid leave for mothers of newly born babies. the $3 payback per hour is not sufficient to justify the training investment if wages remain as they are. firms usually must incur various costs associated with laying off its workers. Suppose that after training. and paying them severance allowances. and the company calculates that to recoup its investment costs the workers’ wages must be $5 per hour below their marginal productivity. Employment will fall as the firm fails to replace those who leave. Firing costs are quasi-fixed. When plants close. Thus. being sure to define what you mean by short-run and long-run! Answer. The decline in employment will stop when the marginal revenue product of labor is once again $5 greater than the wage rate. workers will not be laid off. Assuming wages remain the same. 4. 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 . How might this change affect (a) the number of employees hired in the industry. and the decline in employment will eventually serve to raise the marginal productivity of labor. Suppose that industry X finds itself in a much more competitive product market than it used to face. because they are associated with workers. when training investments have already been concluded. this will induce firms to (a) hire fewer workers. 6.Answers to Even-Numbered Review Questions 2. wages are set at $5 below marginal productivity. analyze the labor demand effects of mandated paid child-care leave on women of childbearing age and on women past childbearing age. not hours of work. including processing necessary forms. and (b) work those they hire for more hours.
teams would no longer have incentives to scout and train their own players. while the latter will tend to increase it. 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. teams are paying the salaries of their minor league players and expending other resources on their training without receiving any revenues in return. and they would tend to adopt a strategy of "raiding" players already trained by other teams. The former will tend to reduce demand for their services. 8. These costs represent investments in general training. the player can become a "free agent" and choose any major league team on which to play. but derive no revenues from. the quasi-fixed nature of the cost implies that their employment will fall more than their average hours of work. which can only be done by paying a wage less than marginal productivity. will reduce the demand for younger women. The major effect of immediate free agency would therefore be to destroy the current minor league arrangements for training players. 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). 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. Immediate free agency might also cause independent baseball training schools to arise. with wages remaining equal. for whom the costs of employment are unaffected. If players were able to become free agents immediately upon making it to the major leagues. After six years. with immediate free agency. Thus. with tuition charged directly to the trainees. 29 . Teams offering the training would therefore have no way of recouping their investment expenditures. 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. The major league teams might give up their minor league teams and rely solely on colleges for training professional baseball players. teams that did not train these players would bid their wages up to a level equal to their marginal productivity.normal earnings). there will be both scale and substitution effects. 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. For older women. Very few of their trainees (perhaps 5%) actually make it to the major leagues. but if they do they are bound to the team that owns their contract for a period of six years. 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. This increased cost. their minor league teams. The overall effects of this policy on the demand for older women cannot be predicted from theory alone (however.
if W0 + Z . One reason firms are slow to hire in expansions is that they are slow to lay off workers during a recession.W1)/1. the cost of training is $50 and the discount rate is 10%..” Comment.MP0 < (MP1 . is this statement likely to be correct? Why? Answer. As productivity rises during expansion. because firms are slow to hire new labor. 3. “Low wage jobs provide fewer hours of work than highwage jobs. Our team is in no position financially to eat the rest of his contract. A baseball team that has committed itself to a four-year contract has made an investment. Plug in the values to solve for W1 at the breakeven point.W1.W1)/(1 + r). Workers in whom the firm has made an investment are paid less then the value of their marginal product.$100 = ($200 .” Using economic theory. I couldn’t get rid of him. so that the firm can recoup investment costs. i. and if the training in high wage jobs is firm-specific. Suppose that a firm is considering training a worker. 2. The worker's MPL is $100 during the training period. of course. 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). He’s in the third year of a four-year. in the hopes. employers will want to substitute longer hours of work 30 . but rises to $200 in the post-training period. $24million deal. the firm will make a profit. so W1 = $145. 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. An author recently asserted. “Labor productivity growth usually accelerates in the first year of an expansion. Answer.1. or $50x1. The manager of a major league baseball team argues: “Even if I thought Player X was washed up. $100 + $50 .e.1 = $200 . 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. Answer. The worker's wage is $100 during the training period. 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. If the post-training wage is less than $145. Suggested Essay Questions 1. The cost has been “sunk. Low wage jobs involve less training than high wage jobs.Answers to Even-Numbered Problems 2. One recent magazine article on economic recovery from a recession argued. of receiving a return.” Analyze the manager’s reasoning using economic theory.” so it is of no relevance to any decision about how to use the player during the contract period.
Thus.for hiring more workers. it is consistent with economic theory for employers to require longer hours of work for workers with more skills. 31 .
trends in these measures are presented and discussed. 32 . these forces can be graphically depicted. 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). holding the wage constant. 2. The major forces affecting labor supply are preferences. The substitution effect is defined as the change in hours supplied attendant on a change in the wage (price of leisure). The five assumptions underlying indifference curves (a graphic depiction of preferences) are discussed. 4. Measures of aggregate labor supply generally focus on labor force participation rates and weekly hours of work. 3. List of Major Concepts 1. and income. The incorporation of information on wages and income into the drawing of budget constraints is illustrated. 6. and the supply of labor is the focal point for beginning our analysis of labor supply theory. holding income constant. 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). One is to fix and define more precisely the concepts of income and substitution effects. 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. building upon what students know concerning product demand. The relationship between the demand for leisure. the primary purpose of Chapter 6 is to present an analysis of an individual's decision concerning whether and for how long to work.CHAPTER 6 .SUPPLY OF LABOR TO THE ECONOMY: THE DECISION TO WORK Beyond introducing some descriptive material on labor force trends in this century. The income effect is the change in hours supplied for a given change in income. the demand for other goods. The analysis begins with a section that discusses the choice process verbally. 8. Graphical analyses of the income and substitution effects are presented. 7. The second is to equip students with a tool necessary to analyze many policy issues affecting work incentives. and introduces the concepts of income and substitution effects (they are more rigorously dealt with later in the context of a graphic analysis). Our graphic analysis is intended to accomplish two ends. wages. 5.
First. 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). from both nonexperimental cross-section data and experimental studies. Analyses of the budget constraints created by several government income support programs are presented.5X but those who did work got $0. This quotation is correct. 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 substitution effect dominates the income effect. 10.) 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. 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). because for labor force participation decisions. the eventual outcome is theoretically unclear. Analyzed are those with "skikes. employees permanently injured on the job receive a payment of $X each year whether they work or not. 4. The way the workers' compensation system works now. the wage rate is increased by 50 cents an hour. The strength of the income effect is relatively weaker when the initial hours of work are smaller. and those with positive effective wage rates (as illustrated by an analysis of the Earned Income Tax Credit program).” Answer. with this change in the way workers' compensation payments are calculated? Answer: This change in workers' compensation has two effects.5X. The effects of these changes can be seen in the figure below. Answers to Even-Numbered Review Questions 2. (We assume here that the change in workers' compensation payments is not so large as to influence market wages. are presented. The concept of "reservation wage" is defined and illustrated graphically. this subsidy would be in addition to the wages paid by their employers).9." those with zero net wage rates (including those with work requirements). it reduces the subsidy for people who do not work from $X to $0. for those who work. What would be the change in work incentives associated. 10. Empirical findings with respect to the labor/leisure choice.5X plus workers' compensation of 50 cents for every hour worked (of course. 33 . Evaluate the following quote: “Higher take-home wages for any group should increase the labor force participation rate for that group. however. On the other hand.
the worker faces a clear-cut strengthening of work incentives under the new program. too. However. One alternative was to reduce the benefits paid to all DI recipients but make no other changes in the program. The other was to maintain the old benefit 34 . 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. 6. however. To the left of point E. that Congress was concerned about the work disincentives inherent in this program. 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. and that the relevant committee was studying two alternatives for increasing work incentives among those disabled enough to qualify for it. however. Thus. there are income and substitution effects that work in opposite directions. along segment EF. Suppose. 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. the new program would have an unpredictable effect on work incentives. other things equal. 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. Segment DE has a steeper slope than the previous budget constraint (BQ and it also lies to the southwest of BC. If. thereby creating an income effect that reduces work incentives.Along segment DE there is a clear-cut strengthening of work incentives. Thus. the worker's tangency point along BC was to the left of point E.
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. Others may have preferences that preclude work (case e). Thus. cases a. Compare. depending on their preferences and the extent of the cut. However. it is not clear from theory which proposal would have the stronger work incentives. (The use of graphic analyses will be of great help to you. 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. and c below.) Answer: The proposal to reduce the average DI benefit may cause recipients to seek work or it may not.levels (for those who receive them) but allow workers to earn $300 a month and still keep their benefits. Analyze the 35 . some of those who medically qualify for DI but would now work may decide to cut their hours of work (case f). for example. b. Analyze the work incentive effects of both alternatives. Those who earn over $300 per month would lose all DI benefits.
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).
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.
but household production. we point out the tripartite choice between market work. and the interdependency of the spouses' labor supply decisions. 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. Instructors facing severe time constraints may wish to skip this chapter. of course. The chapter begins with an introduction to the concept that households combine time and goods to produce commodities that are consumed at home. causing intertemporal substitution effects. AND THE LIFE CYCLE Chapter 7 analyzes the labor supply decision (the decision to work for pay) in the context of household production theory. The household production context of the labor supply decision. 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. and leisure in analyzing why the substitution effects for women might be expected to be larger than those for men. whether both spouses will work for pay. in this context. In particular. do wages). 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). The insights provided by the analysis in Chapter 7 are refinements of the basic concepts introduced in Chapter 6. the concepts of household production also lead to a discussion of labor supply over the life cycle. Further.CHAPTER 7 . 39 . We discuss such family labor supply decisions as who stays home to care for children (if anyone does). yields insights about that decision that go beyond those of Chapter 6. thereby raising the issue of family labor supply decisions. Chapter 7 summarizes some recent directions in which labor supply theory has been going. In this chapter. These insights are discussed after our brief introduction to household production theory in the first section. This framework quite naturally leads the discussion of labor supply into the context of families. and to sacrifice Chapter 7 would mean forgoing concepts and empirical work close to the frontiers of economic analysis. household work. The chapter concludes with a policy analysis of "child support assurance" programs. and they do not contradict the insights or predictions of Chapter 6. Labor supply over the life cycle is also affected by the way wages typically vary with age.LABOR SUPPLY: HOUSEHOLD PRODUCTION. Our discussion of the life-cycle aspects of labor supply begins with the observation that household productivity does indeed vary over the life cycle. since one's household productivity varies considerably across the life cycle (as. the primary alternative to working for pay is not assumed to be leisure. however. The "additional worker" and "discouraged worker" hypotheses are also discussed in this context. However.
but they must clearly take account of the partners' marginal productivities at home and the wages they can command in the "market. Graphic analysis of the choice of optimum retirement age is presented. 4. which tend to create budget constraints with zero net wage rates. 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. adds a third dimension of choice about time usage (market work. for those who worked for pay in the absence of such programs. 5." 6. the pure income effect created by support assurance programs should tend to induce fewer hours of paid work. 2. However. household work. 9. The latter model. child support assurance programs preserve incentives to engage in market work. emphasizing how delaying retirement by a year can affect the present value of one's total income over the remaining years of expected life. Child support assurance programs ensure transfer payments to custodial parents based on the age and number of children. Joint household production decisions (which spouse. however. 7. 8. 3. not on income. The "discouraged worker hypothesis" and the "additional worker hypothesis" are discussed in the context of household production theory. if either. 40 . 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. As wages change. should remain home instead of working for pay) have yet to be completely modeled. the method chosen is in part a function of the price placed on time. Household commodities may be produced by time-intensive methods or by goodsintensive methods. there will be changes in the time intensity of commodities consumed as well as in the time intensity of household production technologies. In contrast with welfare programs.List of Major Concepts 1. The basic concepts of household production theory include the combining of goods and time to produce commodities that yield the family utility. leisure).
The text pointed out. she will experience both an income and a substitution effect. if the husband's wage increase caused him to work more. This increased income without a corresponding increase in her wage rate tends to induce her to work fewer hours. the answer to this question really depends upon whether one assumes the two spouses have household productivities that are interdependent. labor saving advances in households. Declining fertility rates tend to reduce the productivity of hours spent at home. Primary among these was the rise of the clerical and professional sectors. Relate each of these factors to the household production model of labor supply that was outlined in Chapter 7. Is the following statement true. and increased urbanization. as well as increased educational levels. she tends to work more. "If a married woman's husband gets a raise. 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. and some of them served to increase the strength of the substitution effect relative to the income effect. However. to increase the wage rate that women can command). they must make their labor supply decisions jointly. Increased urbanization also tended to make it easier to substitute goods for household production. that spouses may make their labor supply decisions jointly. 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). All these factors tended to raise market productivity relative to household productivity. serve to increase productivity in paid employment (that is. theory cannot predict which one is dominant. if a married woman's husband gets a raise. and if she already works. if so. if her wage rate rises. declining fertility rates. or uncertain? Explain. while the invention of labor saving devices in household production make it easier to substitute goods purchased with cash for time at home. that raise (to her) has an income effect. false. 4. 41 . the increased education of women. For example." Answer: Ignoring the question of joint labor supply decisions. a wage increase will increase her chances of labor force participation. she tends to work less. 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. the wife may also decide to work more if they are complements in household production (or consumption). though. Thus. but if she gets a raise. Increased opportunities in the clerical and professional sectors.Answers to Even-Numbered Review Questions 2. If she is out of the labor force.
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). However. Suppose that. Assume that a state government currently provides no child care subsidies to working single parents. 8. where at a given time individuals have an expected lifetime wealth and also face predictable changes in their wage rate as they age. Employing a theory of life-cycle allocation of time. and suppose the government adopts a child-care subsidy that pays $3 per hour for each hour the parent works. 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. With these studies there is a substitution effect – leading to more work as wages rise – but no corresponding income or wealth effects. 42 . if the wife earned an income equal to her husband's throughout the years. up to 8 hours per day. The latter studies are in the pure life-cycle mode of analysis. Suppose that child care costs are hourly.6. but that it now want to adopt a plan that will encourage labor force participation among single parents. she would be determined to qualify for half of the assets at the date of divorce. Put differently. 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. how could an equitable settlement be determined in the case of a woman who stayed home. Draw a current budget constraint for an assumed single mother (net of child care costs). Suggested Essay Questions 1. Several studies have indicated that for prime-age males. 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. under state law. 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. and then draw in the new constraint. the income effect of a wage increase tends to dominate the substitution effect. Thus. In both cases there are both substitution effects and income effects of wage changes. If the old budget constraint is AB below. raised the family's children. a woman who performs household services saves the family money that it would otherwise have had to spend. holding constant the individual's expected lifetime wealth. For a discussion of how these services can be valued. 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. Discuss the likely effects on labor force participation and hours of work.2. Based on what you have learned in Chapter 7. Answer. other things equal. explain the apparent discrepancy. see Example 7.
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. 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. however. some workers who were out of the labor force before will now join. some people working over 8 hours a day before may reduce their supply of hours and move to point C on the constraint. the budget constraint is segment DB. 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. Among those single parents not working before the subsidy is adopted. Income B D C A 8 Hours of Work 2. Suppose child care costs are hourly. and those who do will 43 . In the drawing below. so the net effect is not predictable. Assume that a state government currently provides no child care subsidies to working single parents. the higher wage rate will tend to increase labor force participation (the substitution effect dominates for participation decisions). the new constraint is ACDE. and then draw in the new constraint. those with flatter indifference curves will find that their utility is maximized at point D. the pre-subsidy constraint is AB. For those already working (tangencies along AC). Thus.after that. and that the government adopts a child-care subsidy of $20 per day if the single parent works 6 or more hours per day. However. but that it now want to adopt a plan that will encourage labor force participation among single parents. which is parallel to AB). the income effect and substitution effects of this wage increase will have opposite tendencies on the hours of work. Thus. Answer.
desire jobs offering exactly 6 hours of work per day. For those along AC before (working less than 6 hours per day). 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). Income E B D C A 6 Hours of Work 44 . For those working more than 6 hours per week before. 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).
The application in this section of the chapter relates to the regulation of employee benefits. it seeks to move students from concepts they are familiar with to new concepts and tools. List of Major Concepts 1. 5. Employee preferences are graphically expressed in the concavity and slope of indifference curves. Again. Following the practice in earlier chapters. Once the essential assumptions and predictions of economic theory in this context are explained. particularly pensions.CHAPTER 8 . we have added an appendix that analyzes worker choice of jobs that have different probabilities of layoff.COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS Chapter 8 introduces students to the concept of compensating wage differentials. In the context of full information and choice. 45 . we introduce students to a graphic analysis that is intended to yield additional insights. Compensating differentials play a dual role in allocating labor to unpleasant jobs and in compensating those who accept unpleasant work. worker behavior will generate compensating wage differentials for job characteristics that are unpleasant or costly. 4. and in so doing elucidates certain issues not commonly understood. This appendix offers another application of the theory of compensating wage differentials to an interesting policy problem. 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. For those who wish to enrich the coverage in Chapter 8. 3. 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. Employers with different costs of eliminating unpleasant job characteristics can be graphically represented. 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. A market equilibrium curve (or offer curve) is derived from the zero-profit isoprofit curves of the employers in the market. Policy implications are related to occupational safety and health legislation. 2. The prediction that there will exist compensating wage differentials for unpleasant work rests on assumptions of utility maximization. 6. The analysis also introduces the student to the notions of "risk aversion" and the willingness to pay for insurance ("certainty"). worker information. and worker mobility. We first apply the concepts of hedonic theory to a "bad" job injuries.
other things equal. If workers have alternative job offers that pay the same wage but offer better working conditions. 11. 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. employees who are least averse to an unpleasant job characteristic become employed with firms that find it most expensive to eliminate that characteristic. (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. Even the greediest profit maximizer must obtain a work force. their behavior will force even the most greedy executives to pay higher wages for filthy.7. 9. (Appendix) Some job characteristics normally considered bad may be considered good by some workers (layoffs may be preferred if they are known in advance). they will accept those offers and turn down work at the more dangerous or filthy workplaces. If workers are informed about job hazards and have a choice about the jobs they take. Statement 1: "Business executives are greedy profit maximizers. The theory of compensating differentials can only be tested using techniques that control for other influences on job characteristics. and to do so must pay a wage that workers will accept. 8. Their behavior then will force owners to either pay the compensating wage differentials or clean up the workplace. If the market is working properly. (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. 14. and the degree to which layoffs cause the worker's income each year to fluctuate. 13. 12. 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. dangerous work. 46 . 10." Statement 2: "It has been established that workers doing filthy. caring only for themselves. Both statements can be simultaneously true. dangerous work receive higher wages." Can both of these statements be generally true? Why? Answer. if not all costs or benefits of the decision are borne by those making them). The mix of wages and benefits in the compensation package depends on both employee preferences and the trade-offs employers are willing to make.
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). Answer. so that even if the Supervisor's salary is low the job may attract a satisfactory flow of applicants. Answer. the affected employers must reduce their wages (to keep overall costs in the competitive range). Alternatively. From the perspective of normative economics. Thus. decline by enough to fully offset the added costs of more insurance. the wages in firms previously offering less insurance will decline. If the Supervisor is able to extract under-the-table payments from these workers. This means that the wages they receive. Use economic theory. To now compete with their competitors in the product market. or cannot. If the labor market is perfectly functioning. less any bribes they must pay. both positively and normatively. we would like to know if this mandate improves the welfare of the workers affected. 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. 47 . then their utility will decline. it is an indication that the wages paid by the city are relatively high.000 in the event of death. if wages do not. to analyze the effects of this mandate on employee well-being. then employment among these employers will fall. must be at least equal to the prevailing wage. Under-the-table payments provide a supplement to the Supervisor's regular salary. Suppose highway workers in a certain city are required to give the Supervisor of Highways an under-the-table payment of $X per year. one can look upon the bribe as an undesirable element of employment for which the workers would have to receive a compensating wage differential. 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). can be low relative to the market. 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. mandating that employers offer at least $50. Suppose that Congress were to mandate that all employers had to offer their employees a life insurance policy worth at least $50. From the perspective of positive economics. If the market is not allowing workers to “buy” (in the form of lower wages) the life insurance they want. Of course. by analogy.000 in life insurance will obviously have no effect on those who are already offering that much or more. It is thus likely that low-insurance employers were paying higher wages than those offering more insurance. To be competitive in the labor market. but it will add to the costs of those who were previously offering less. If the mandate forces them to take some other mix. workers are able to obtain the combination of wages and life insurance that maximizes their utility. The Supervisor's wage.4. We would expect wages for highway workers in the city to be high relative to the market wage. 6.
provided that the level does not climb above S*. W*. This wage equals W*. This statement is not correct. The safe mines can thus be highly selective about the applicants they choose.) 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. (The New York and California isocost curves are the same. Consider the conditions of work in perfume factories. Answers to Even-Numbered Problems 2. Both sets of mines must pay the same wage rate and offer the same fringe benefits. Put differently. and they will tend to hire the most dependable.) Answer. will have to take who they can get (those workers not chosen to work in the safe mines). when working conditions differ. Draw a diagram using isocost and indifference curves that depicts the situation. with very few applicants. where the union has forced all wages and other compensation items to be the same. they start to dislike it.) 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. To understand how the market would adjust. The dangerous mines. most motivated employees. in New York it is 0. workers dislike the smell of perfume. (If it rises above S*. and this is tantamount to the receipt of a compensating wage differential. But a natural corollary of this is that. They both advertise for help and.8." 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. compensating differentials cannot exist. while in California workers appreciate the smell of perfume. 48 . hardest working. the theory of compensating wage differentials says that people of equal skill will receive different wages when working conditions differ. Thus. Because all mines must pay the same wage. people of different skills might receive the same wage. In New York perfume factories. highly productive workers getting wage $X. Safe mines will have high quality. but their indifference curves differ. the safe mines receive many more applications than the dangerous mines. let us assume that we have a set of relatively safe coal mines and a set of relatively dangerous coal mines. The level of smell in California is S*. In both cases workers in less desirable circumstances receive higher wages than they would otherwise receive. workers of unequal productivity would receive the same wage. assuming workers quickly find out which mines are safe and which are dangerous. while the dangerous mines will have lower quality workers obtaining the same wage. "The concept of compensating wage premiums for dangerous work does not apply to industries like the coal industry. The California workers are paid exactly the same as the New York workers.
while employment grows and wages fall in the large-firm sector. while at the same time prohibiting overtime hours from being worked. If they value the ability to work overtime. applying only to large firms. 49 . (Overtime had been widespread in both sectors. that cuts the standard workweek from 39 to 35 hours (workers are paid for 39 hours even though working 35). This law does not apply to smaller firms in the country. are paid for 39). but the law also prevents them from working overtime. In this latter case.Suggested Essay Questions 1. The higher wages in the latter sector would reflect a compensating differential for the restricted access to a valuable workplace characteristic. 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. and is paid at 50% above the normal wage rate. The immediate effect on workers in large firms is to give them a wage increase of around 10% (work 35. how do you think this law might affect wages and employment in the two sectors? Answer. then more would seek work in that sector. How wages and employment respond depends on the value workers put on overtime work.) Using economic theory. A country passes a law. 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). employment shrinks and wages rise in the small-firm sector. However.
other things equal. and the flexibility in their work lives that most American workers take for granted. “Workers in low-wage jobs lack the basic security.” Assuming this statement if true. 50 . Thus. jobs with low non-wage benefits would have to pay higher wages. the facts in this statement do not contradict the theory of compensating wage differentials. The theory of compensating differentials predicts that. A recent article stated. This statement is implicitly comparing those in low-skilled jobs with those in high-skilled jobs.2. do these facts contradict the theory of compensating wage differentials? Answer. the health benefits. where clearly “other things” are not comparable.
Because investment returns flow in over several years.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. List of Major Concepts 1. We introduce age/earnings profiles and discuss the reasons for their convexity. and psychic losses. 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). 2. Next. 3. When discussing education as a social investment. in which the need for educational investments slows down the supply response to changes in market demand. Investments in human beings are part of the general category of investments. 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. 5. we consider the question of whether education is a good investment. we devote a section to evaluations of government job training programs. Human capital investments are more likely to be made by people who are not present oriented. and we discuss possible biases (including selection biases) inherent in these findings. The second section of the chapter analyzes the relationship between education and earnings.CHAPTER 9 . Implications of this model for both individual and aggregate (market) behavior are then derived. Included in this section is an analysis of the differential convexity among such profiles for men and women. Costs of human capital investments include out-of-pocket expenses. by people who are young. In this context of evaluating education and training as investments. Appendix 9B presents a hedonic model of education and wages that uses the graphic tools of Chapter 8. Investments entail costs in the current term with returns flowing in over later periods. 4. Appendix 9A presents and explains a "cobweb" model of labor market adjustment. The major findings of the literature with respect to the individual rates of return to education are summarized. This hedonic model is useful in explaining several empirical facts about the relationship between education and wages. The chapter begins with a section on the demand for education by workers. and the discussion also serves to integrate the concepts in Chapters 8 and 9. in which a theory of human capital investment is formulated and a formal model of choice is presented. We analyze this question from both an individual and a social perspective. forgone earnings. in situations in which the costs of human capital 51 .
Post-schooling investments reduce actual earnings below potential earnings. Post-schooling investments in on-the-job training can help account for both the convexity and the fanning out of age/earnings profiles.investments are lower. to compensate them for the cost of investment). 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. who expect interrupted labor market careers. 11. rather than an activity that enhances productivity. 15. 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. 9. one's actual earnings approach potential. Variations in the returns to human capital investments call forth supply responses by individuals. Public sector job training programs have created demonstrable earnings gains only for adult women. and if ability is positively related to on-the-job productivity. and the present value of these gains typically exceed program costs. jobs that require more education or training must pay a higher wage to attract workers (that is. 8. If the full cost of education is inversely related to ability. Age/earnings profiles are flatter for less educated workers. and in situations in which the returns to these investments are larger. 6. affecting college enrollments in predictable ways. 10. 14. 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). 12. 7. Evaluations of whether education is a good social investment must consider the hypothesis that education acts as a screening device. reflecting smaller human capital investment costs in their early years and lower growth of productivity. Because education is costly. and as such investments decline over age. 52 . (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). 13. downward biases associated with the failure of monetary earnings to reflect all the benefits of a college education. 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. 16.
That is. the optimum allocation of resources requires that all mutually beneficial transactions be accomplished. Because it makes no major investments in its workers. human capital investments that might have been made will be discouraged. When Plant X closed. Employer Y (which offers no training to its workers) hired many of X’s employees after they had completed a lengthy. Thus. because the retraining program to which X’s former employees had access was “lengthy. Y’s claim is consistent with human capital theory in two respects. The city’s Equal Opportunity Commission noticed that the workers Employer Y hired from X were all young. Answer. and that its hiring standards consist of taking successful graduates of another program). without regard to age. Answers to Even-Numbered Review Quesitons 2. (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. Thus. 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. its own hiring and training costs appear to be negligible (we are told that it offers no training on its own. First. Answer: As indicated in Chapter 1 and elsewhere. the pursuit of wage equalization across skill levels will discourage human capital investment and may result in too few workers entering skilled occupations. in an effort to upgrade the quality of mechanics.” it may well be that only the younger workers from X decided to invest in this retraining. During this investigation employer Y claimed that it hired all of the applicants from X who had successfully completed the retraining program. potentially beneficial human capital transactions may be discouraged. and a shorter period over which benefits are received reduces these benefits. because the acquisition of training and education is costly. From what you know of human capital theory. full-time retraining program offered by a local agency. it therefore has no reason to prefer younger workers. "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. If wages are forced toward equality by government fiat. human capital investments will not be undertaken unless there is a future return to them. These returns normally are in the form of higher wages paid to those with the higher skill levels. and it launched an age-discrimination investigation. Those who are currently mechanics will not be subjected to these requirements. Second. and if these higher wages cannot be paid." Comment. 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. Suppose that the government. 6. What are the likely labor market effects 53 .17. does Y’s claim sound credible? Explain. 4.
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. 8. or to having no repairs at all. Among consumers. lower cost mechanics in the future). 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. whose wages will be increased but who are not subject to the licensing procedure themselves. Reducing the benefits could be accomplished by installing protective devices that make burglaries less likely to succeed. these potential mechanics will either be barred from the market or will have to make training investments that they would not otherwise have made. Put differently. analyze what kinds of people are most likely to engage in criminal activities. or raising the labor-market earnings potential of those currently with the least to lose. to paying the higher cost for high quality repairs. Increasing the costs can be done by increasing the likelihood of catching thieves. who may have preferred low cost. If imprisoned. 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. the criminal loses income from both criminal and noncriminal activities.) The labor market groups that gain are current mechanics. low quality mechanics. 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. Losers will be poorer consumers. the returns to training for those who would have obtained it anyway will rise. because with an investment costs are borne in the present and the returns come later. Using the framework for occupational choice in the long run. Answers to Even-Numbered Problems 54 . and future mechanics of high quality (who will not have to compete with low quality. Many crimes against property (burglary. 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). What can society do to reduce crime? Answer. low quality repairs to doing the work themselves.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 labor market groups that lose include those who would have become low cost.
While this adjustment is taking place.) b. (Find this by setting Ls = -6 + . Draw a graph to show these events. so W = $51. while the demand curve is given by Ld = 50 . the short-run supply of optometrists is fixed. Initial equilibrium W = $35.6W = Ld = 50 .) 55 . Calculate the wage and employment levels in each of the first three rounds and find the new long-run equilibrium.W and solving for W. This is point A in the figure. b.2. Find the equilibrium wage and employment levels. First round: L is still 15. Answer: a. where W = annual earnings in thousands of dollars per year and L = thousands of optometrists.W.W.6W. Assume that this market is subject to cobwebs because it takes about three years to produce people who specialize in optometry. W = 15. a. (Appendix) Suppose the supply curve for optometrists is given by Ls = -6 + . (Find W by plugging L = 15 into the new Ld equation. Now suppose that the demand for optometrists increases and the new demand curve is L'd = 66 .
obtaining a General Equivalency Degree (GED) by part-time study after high school has very little payoff.84 into the new Ld equation. One element of cost is forgone earnings.4 into the Ls equation to find L = 18. so that children who do not now have a school near their home can attend a school without a long commute. which will be nonzero for children who could work. wants to reduce the use of child labor. It also shows. lowers the cost of investing in human capital – and theory predicts that more young students would attend school rather than work. Suppose that it decides to open more schools. perhaps involving living away from home) to school.6. Making schools more geographically accessible. 56 . however. and those who drop out may be viewed as having a low aptitude (or low tolerance) for learning.84. Third round: Labor supply reacts to second round W. (Find this by setting Ls = -6 + .6W = Ld = 66 . If. and then plugging L = 24. then. but this pushes W up to $47. so dropping out may not send the same signal of low aptitude or tolerance. however. Immigrants may come from countries in which high schools are either more demanding or less available. even if they later obtain a GED. A study shows that.16 (see point E). 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. ages 10-14. Analyze how opening new schools will affect child labor.6 into the new Ld equation.W and solving for W. L = 18. is the cost of commuting (time and expense. 2.84 and then plugging L = 18. Answer. Find this by plugging W = $41. that for immigrants who did not complete high school in their native countries. Long-run equilibrium. employers may prefer them to American GED recipients. W = $45. Can signaling theory be used to explain these results? Answer. L = 24. Find this by plugging W = $51 into the Ls equation to find L = 24. for American high school dropouts. these immigrants are certified as knowing the equivalent of American high school graduates. obtaining a GED has a relatively large payoff.6. A second element.4 (at point C). though a GED.Second round: Labor supply reacts to first round wage. Graduating from high school is more or less the expectation for American students. explaining these effects fully. L = 21. Assume that a developing country with a labor force that includes many children. other things equal. but this pushes W down to $41.) Suggested Essay Questions 1.
List of Major Concepts 1. It considers the problem of illegal immigration and uses economic theory to identify the gainers and losers from a more restrictive immigration policy. The chapter also describes and analyzes immigration policy in the United States. U. 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). 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). AND TURNOVER This chapter employs the human capital framework to analyze the phenomena of geographic mobility and worker turnover. 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. immigration policy is. could save some time in the course by eliminating the section of the chapter on immigration policy. costs of finding out about alternatives elsewhere. the section does not directly employ human capital analytics. The lengthy section on U. immigration has tended to become less-skilled in recent years. It demonstrates how the insights of human capital theory can explain the observed patterns of mobility and turnover. Like other investments. the section on immigration concludes with an analysis of the overall effects of immigration (including illegal immigration) on the "native" population. Thus. migration investments can fail to work out as expected. 4. 5. and who are willing to forgo an analysis of the very topical issue of illegal immigration and what to do about it." 57 . 2. including the personal characteristics of those most likely to exhibit either kind of mobility.S. However. while those with distributions that exhibit greater variance will tend to send less-skilled workers to the United States. 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. IMMIGRATION.WORKER MOBILITY: MIGRATION. instructors who want their students exposed to human capital analysis as it applies to geographical mobility and turnover. Finally.CHAPTER 10 .S. Worker mobility can be viewed as a human capital investment. resulting in "return migration. or high costs of the move itself. 3. motivated by our human capital analysis of individual migration. of course.
Answers to Even-Numbered Review Questions 2. This move will shift the supply curve for 58 . 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. What would be the labor market effects of such a policy? Answer. 8. interregional migration would be increased as a response to this migration subsidy. The human capital model can be used to model quit behavior. A large influx of immigrants will tend to lower wages in the relevant labor markets and create more employment. However. but only in special circumstances would an influx of X immigrants take X jobs away from "natives. leading to monopsonistic behavior. when the costs of migration are reduced by the subsidy. If there are high costs of migration. "Matches" between employer and employee are improved through the process of voluntary quits and involuntary layoffs. 12. 9. and employment would grow in areas of high economic opportunity. 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. If immigrants receive wages equal to their marginal product. more people will respond to a given wage differential and move from the depressed area to the area of better opportunity. the pattern of quit rates across age groups. 10. 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.6. Immigration may increase product demand and the demand for other skill grades of labor. and international differences in quit rates. 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. then there would be incentives for workers to leave the low wage area and migrate to the higher wage area." 7. 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. Human capital theory can shed light on the cyclical pattern of quit rates. Clearly. 11.
Answer. Moreover. 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. However. there will be a reduction in wages and employment in the skilled markets. if the American unskilled 59 . unskilled native workers benefit by the imposition of jail sentences on illegal immigrants who are apprehended. if skilled and unskilled workers are gross substitutes. the reduction of unskilled employment and the increase in the unskilled wage may cause the demand for skilled workers to decline. 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). 6. Jail sentences for illegal immigrants would reduce the net gains from immigration. if skilled and unskilled workers are gross complements. the wage rate lies above the equilibrium wage). those who decide to immigrate and are not apprehended will be better off because they will receive higher wages in the unskilled market. Employment in the unskilled market goes down. If the problem in the sending area is one of unemployment due to wage inflexibility in that area (that is. How would a decline in the wage gap between the skilled and the unskilled affect immigration to the United States? Answer. 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. If there is a leftward shift in the demand for skilled workers. although it may not affect the wage rate. this reduction should raise wages in the unskilled labor market. (Of course. Analyze the effects of this increased penalty on the wages and employment levels of all affected groups of workers. Suppose that workers eventually adjust to this gap by investing more in education. Thus.) Workers from outside the United States who would otherwise have become illegal immigrants (but who are now deterred from immigration) will be worse off. then an increase in outmigration will reduce unemployment in the sending area. shift the supply curve for the area of better opportunities to the right. Thus. Suppose the United States increases the penalties for illegal immigration to include long jail sentences for illegal workers. even if the probability of being apprehended is small. although unskilled employment among natives increases. Immigrants at least implicitly compare the wages they can expect in the United States with those they can expect in their place of origin.the depressed area to the left. 4. 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). and thus reduce the wage differential between the two areas. assuming these immigrants are unskilled workers. The reduced net benefits from migration should reduce the number of illegal immigrants coming into the country and.
60 . for example). If immigration increases the number of rough laborers hired from 50 to 60. so W = $5 per hour. and more incentives for unskilled immigration from countries with less-equal distributions. This will increase from area W1AB in the figure to area W2AC. Thus. Skilled workers tend to come from countries with more equal earnings distributions than found in the United States (many European countries. the United States should experience a rise in unskilled relative to skilled immigration.5 = $125 per hour.5 = $180 per hour. See the figure.wage rises relative to the skilled wage.5(base x height). 60 = 100 – 10W after the immigration. Find the wage rates by plugging the employment levels into the Ld equation. and the area of W2AC is 60x$6x. Answers to Even-Numbered Problems 2. say. The area of the triangle is . 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. there will be reduced incentives for skilled immigration from Europe. When the American earnings distribution becomes more equal. so W = $4 per hour. 50 = 100 – 10W initially. Suppose that the demand for "rough laborers" is Ld = 100 – 10W. profits have risen by $55 per hour. 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. Further. so the area of W1AB is 50x$5x. while unskilled workers tend to come from countries (often developing countries) with less equal earnings distributions.
2. these benefits will also serve to attract those who value the amenities of parties. 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. Country B has no such restrictions. The company’s president states that it is her goal to ensure that “workers have a serious emotional connection to our company. showers.” The company is unusual in that it offers air conditioning. The provision of these non-wage benefits is costly. Would you expect the wages these two countries pay for otherwise-comparable male immigrants to be roughly equal? Why or why not? Explain. Country A does not allow women to work. especially among workers who do not value the nonwage benefits very highly. and so forth – and because these amenities are unusual. and in what ways might they help? Answer. drive or go out of the house without a chaperone. education in English. The supply of immigrants to A will be restricted. will tend to increase turnover at the firm. and monthly parties. 61 . who perform menial jobs that local workers are unwilling to perform. those who place a high value on them will tend to remain with the firm (the could not get them elsewhere). Lower wages. by themselves. The wages in A will have to be higher in order to attract immigrants.Suggested Essay Questions 1. Answer. air conditioning. and the theory of compensating differentials suggests that their presence will serve to reduce the wages that their workers could otherwise command elsewhere. A particular manufacturing company employs low-skilled workers in a developing country in which turnover among such workers is generally high. In what ways might these policies make it difficult to retain employees. Two oil-rich middle-east countries compete with each other for the services of immigrants from India and Pakistan. However. tuition for English courses.
profit sharing. alternatively. we turn (in sequence) to an analysis of how motivation is affected by the basis of pay. After discussion of some general issues relevant to worker motivation. 62 . 7. we discuss in turn issues related to piece rates. Compensation schemes are jointly chosen by employer and employee. 2. efficiency wages. Dividing a "surplus" between marginal revenue product and the alternative wage is critical to a self-enforcing employment contract. Thus. It begins with a discussion of the employment contract.CHAPTER 11 . and the sequencing of pay. the level of pay. 3. the latter method requires that the measures of their performance be correlated with their effort and the employer's objectives. Productivity varies across workers and over time for a given worker. 5. For an implicit contract to be self-enforcing. and deferred payment schemes. Because of group considerations. but they are useful in eliciting signals about worker characteristics. 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. List of Major Concepts 1. 4. Contracts can be both formal and implicit. How this contract can be made self-enforcing within the context of asymmetric information is the principal focus of this section. promotion tournaments and the issue of "career concerns. and hourly pay (including merit pay). 8. which is largely implicit and legally unenforceable. " The chapter ends with a short section on two puzzles: why earnings increase with tenure and why they increase with firm size. commissions. Workers can be motivated to be highly productive by close supervision or by having their earnings tied to their performance. motivation techniques must take account of the perceptions of fairness and issues of group loyalty. with the latter being incompletely specified and hence legally unenforceable.PAY AND PRODUCTIVITY This chapter explores in detail the relationship between compensation and productivity. 6. the parties can rely on signals that they are contracting with the "right kind" of person. Schemes that tie pay to individual productivity must take account of worker risk aversion. and it involves taking the initiative in a myriad of hard-to-observe ways that advance the employer's interests. this surplus can be created by labor investments of one sort or other.
The higher labor costs associated with greater firm size suggests that the labor supply curve to a firm may be upward sloping. 16. 10. Time-based pay with merit increases can be based on either absolute or relative output. but relative measures can induce counterproductive behaviors among employees. hard-working employees and offers incentives for current workers to put forth effort. The earnings of piece-rate workers usually exceed those of hourly paid workers performing the same tasks. 13. 11. 12.9. Second. by increasing their wages employers can increase the productivity of their workers (the efficiency wage). What are they? Answer. if stability of hourly pay is preferred to the potential fluctuations of piece rate pay. As firms increase in size it becomes increasingly costly to monitor worker effort. absolute measures do not correlate as closely with individual effort. or "quality") dimensions. 18. Output is not normally one-dimensional. One scheme involves a period of underpayment followed by later overpayment. this option promises handsome future rewards for current effort. First. workers will put forth little effort to increase output along the other (subjective. Group incentive schemes run the risk of creating "free rider" problems. and one way to cope with this monitoring problem is to pay higher wages. piece-rate pay will appeal most to workers of 63 . Efficiency wages are most effective when the employer-employee tenure is expected to be long. and this may explain monopsonistic behavior among firms in the labor market. Promotion tournaments also have signaling and incentive value. then part of the "earnings premiums" enjoyed by piece-rate workers is a compensating wage differential. 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. the sequencing of pay is also an option. Answers to Even-Numbered Review Questions 2. With long expected tenures. 15. 19. 17. and if pay is based on objectively-measured aspects of output ("quantity"). which has both signaling value in obtaining future-oriented. hence. Theory suggests three reasons why. 14. Employee "career concerns" (which can involve future payoffs with other employers) can both distort and enhance efforts with one's current employer. Employees who feel generously treated by their employers may put forth greater effort.
Drivers paid by the piece are motivated to deliver more cases per day. 6. Their incentives to make an additional sale are therefore stronger. piece rates increase the incentives of given individuals to expend effort. 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). such workers are most likely to accept jobs paid by the piece. 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.50 per hour into a fund that they will receive as a lump-sum payment if they work through Labor Day (typically. Some real estate brokers split the commission revenues generated by each sale with the responsible agent. Which agents would you predict to have the larger volume of sales.00 per hour and putting aside $1. How can the park now address the problem mentioned in your answer to (a)? Answer. First. 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. (a) The park has apparently had trouble keeping its teenage workforce through Labor Day. therefore. This compensation plan will appeal most to job applicants who intend to 64 .00 per hour. and then allow the agents to keep the entire commission from each sale they make. There are two reasons to expect that agents paying an up-front fee will generate more sales. Which company is more likely to experience higher rates of traffic accidents among it drivers? Why? Answer. Second. and one would expect them to work longer hours and engage in more intensive efforts to increase their sales volume. paying them $4. One company pays its drivers an hourly wage. An amusement park open only in the summer hires teenagers to operate its rides and concession stands.above-average productivity. however. Suppose two soft-drink bottling companies employ drivers whose job it is to deliver cases of drinks to stores. 8. 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). agents can keep the entire commission from each additional sale. its biggest day of the year). They will probably drive faster so they can make more calls. 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. Answer. Thus. which increases their pay. Third. require their agents to pay them (the brokers) money up-front. 4. (a) What problem is the amusement park apparently trying to solve with its compensation plan. Others. and they therefore might have a higher accident rate. having paid the fee. restaurants and businesses.
Answers to Even-Numbered Problems 2. we can find the present value of underpayments and overpayments by simply adding them up. Assume that this wage is high enough to attract workers from alternative jobs.) Triangle A (the initial underpayment) and triangle B (the later overpayment) are equal when T = 40 years. 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.work through Labor Day (that is. Triangle A exceeds triangle B if retirement comes before tenure equals 40 years. For a typical worker at the firm MRPL = 10 + . For how many years will the firm "underpay" it workers? Answer: The graph shows the wage and MRPL lines. The worker's wage per hour is W = 8 + . If workers retire after 35 years. and that the expected tenure of a typical worker is 35 years. substitute capital for labor. (b) If the plan is struck down. 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). and it also gives current workers incentives to stay on through then. 65 .the early underpayments exceed the later overpayments. It could invest more in screening applicants. will this plan be profitable for the firm? Explain. (Because the discount rate is zero. 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). where T = the number of years which the worker has been employed at the firm and MRPL is measured in dollars per hour.1T. The firm will adopt the plan because it expects to profit from it -.2T. that the discount rate for the firm is 0. it has signaling value). which cross after 20 years.
In this case. producing a high-quality course in a brand new environment requires creativity in dealing with issues that cannot be foreseen. “As the post-war baby-boomers reach their 50s. 2. 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. while Firm Y is supplying the course content materials. 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). Firm X is supplying the computer specialists. Second. Production incentives are most effective when they perfectly align the interests of workers and owners. Firm X wants Firm Y to adopt financial incentives for its employees working on this project to finish their work according to a deadline. Japan’s lifetime-employers are carrying the cost of 66 . First. so tailoring incentives to deadlines might not align the interests of employer (who wants quality) and employee (who wants to meet a deadline). so delays or mistakes made by one team will affect the ability of the other to meet the deadline. the output of Y is not completely under the control of its workers. 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. we must question whether either condition is met. put differently. X and Y are jointly producing these programs.Suggested Essay Questions 1. Both firms will share in the profits of the courses they jointly produce.
it is consistent. and it is necessary to attract workers to the firm. 67 . 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). The later overpayment serves to compensate workers for their earlier underpayment. The purpose of this scheme is to provide incentives for employers to stay with the firm and work diligently (and honestly).” Is this comment consistent with economic theory? Explain. Answer. Yes.paying their senior workers more than they are worth. Employers offering lifetime jobs have the ability. lest they be discovered shirking and lose the opportunity for overpayment. and often the incentive.
AND ETHNICITY IN THE LABOR MARKET This chapter represents a comprehensive inquiry into wage differentials across gender. legal decisions involving seniority. with special emphasis on the effects of such hard-to-observe factors as English language proficiency. racial and ethnic groups. and school quality. and theories involving collusive action).GENDER. The second major section of the chapter analyzes theories of market discrimination. Earnings by ethnicity are also discussed. the analysis includes a review of attempts to estimate the effects of discrimination. 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. Income disparities between men and women may have their roots in different incentives to acquire productive characteristics. List of Major Concepts 1.CHAPTER 12 . and the theory of statistical discrimination is explained. 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. in which the overall differential is broken into two parts: that associated with measurable productivity differences and that associated with unobserved (unexplained) differences. Becker's theories of employer. The appendix to Chapter 12 contains an introduction to the problems of estimating comparable worth "earnings gaps. RACE. customer. Current labor market discrimination is said to exist when the market places values on personal characteristics of workers that are unrelated to productivity. cognitive achievement." 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. 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 employee discrimination are discussed. along with noncompetitive models of discrimination (occupational crowding. 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 closes with an analysis of the federal contract compliance program. and the emerging comparable worth remedy. search-based monopsony. It begins with a section on earnings differences by gender. Black-white earnings differentials are analyzed next in a subsection that includes a brief treatment of differences in the ratios of employment to population. dual labor markets. 68 . In each case. 2.
one must determine what the earnings ratio would be if the protected class and white males had the same productive characteristics. the adjusted differential is in reality an unexplained differential. they will act as if they believe the marginal product of those workers is lower than it really is. the behavior of prejudiced employers will reduce demand for the minority group and cause a wage differential to exist. and those who are the most discriminatory will make the least profits. Human capital and language-proficiency differences account for A but 3 to 7 percentage points of the Hispanic wage differential. Much of what appears to be labor market discrimination against women takes the form of occupational segregation. The size of the differential depends on the size of the minority population relative to the distribution of prejudiced employers in the market. prejudiced employers. When productive characteristics are controlled in an analysis of earnings differentials. 8. seems to be declining somewhat recently. 13. Under employer discrimination. 11. and it could reflect the effects of unmeasured worker characteristics as well as market discrimination. 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. Earnings differentials caused by differences in productive characteristics are termed "premarket. Occupational segregation is one form of discrimination. 10. and it can be measured by an index of occupational dissimilarity. while still rather marked. 7. 6. they account for all but roughly 10 percentage points of the gender wage differential. Thus. 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. it is difficult to distinguish between the effects of occupational choice and those of employer discrimination. 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. 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. 9. To measure the extent of wage discrimination. 5." 4. they will hire fewer such workers than would be called for by profit maximization. However.3. 12. If employers discriminate against some group of workers. which. 69 . however.
prejudiced employers may comply by paying protected-class workers less than white males. 20. and if discrimination raises the search costs of certain groups of workers.14. that counts. genuine. and policies that may appear to be neutral on the surface may nevertheless perpetuate the effects of past discrimination. then monopsonistic behavior will create wage differentials among otherwise identical workers. 18. 15. Employee discrimination generates supply-related behavior that might cause employers to segregate their plants by race or sex if possible. but the theory does not explain how an employer cartel is maintained in the face of clear-cut incentives to cheat. Statistical discrimination should be reduced in situations in which the variance of individual characteristics around the group average widens. 16. Under this standard. a reduction in productivity is. 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. but they do not satisfactorily explain the creation of these groups. from the employer's perspective. Employers are seen as deliberately dividing the labor force to guard against cohesive collective action by workers. 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. 21. Like employer discrimination. 19. Some theorists use collusive action on the part of employers to explain the creation and persistence of noncompeting groups. with customer discrimination. Anti-discrimination programs by the government must set standards for both employment and wages. Courts have moved towards a disparate impact standard. then prejudiced employers will respond to increased wages for protected classes by reducing employment. However. 22. not motivation. customer discrimination implies a shift to the left of the demand curve for the services of a protected class. If a wage standard is the only one applicable. If not. 17. If employment standards are the only ones used. Proving intent is difficult. policies that lead to different effects by race and sex are prohibited unless a business "necessity" can justify their use. wage differentials will arise as a result of the need of employers to retain workers in the prejudiced group. 70 . Both the crowding hypothesis and theories emphasizing the dual labor market suggest the presence of noncompeting groups. by which it is labor market results. If search costs create upward-sloping labor supply curves to individual employers.
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"). 71 . 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. This growth means that measured labor market discrimination against unskilled Mexican immigrants is also growing. the degree to which the firm has incentives to train new employees. “In recent years. 28. 25. The estimated coefficient on the point score variable is an estimate of how much a unit change in that variable affects earnings. 26. the existence (and size) of labor market discrimination depends on the wage gap between unskilled native whites and unskilled Mexican immigrants (that is. because native whites are better educated and more skilled. (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. (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. 27. the wage gap between skilled and unskilled workers in the United States has grown. the willingness of workers to commute to the firm. The Federal Contract Compliance Program seeks to shift the demand curve for protected classes to the right. Answers to Even-Numbered Review Questions 2. on average. however. Answer. and working conditions in jobs for purposes of pay comparisons. Because of occupational segregation. 24.” Comment on whether the second part of this statement is implied by the first part. wages. and quit rates for protected-class workers). mandating wage increases for women could reduce the incentives of employers to hire them.23. responsibility. Realistic estimates of availability should account for the compensation policy of the firm. However. The comparable worth remedy is based on comparing the skill content. It is true that rising inequality causes a greater gap between the average wages of native whites and unskilled Mexican immigrants. This relationship can then be used to estimate what women would receive if they were paid on a basis comparable to men. 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). and the extent to which job applicants can be induced to move to the firm's labor market area. men and women often occupy dissimilar jobs.
the central city schools must raise wages (this wage increment would act as a compensating wage differential. suburban schools will not be able to attract black teachers (who will find the higher wage at the central city schools more attractive). 6. the same. by hypothesis. it is not obvious that this particular university is engaged in the behavior we could attribute to employer discrimination. given a lower market wage for women relative to comparable men. 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. Assume further that there are not enough black teachers to fully staff the central city schools. because these schools can attract the white teachers without offering a compensating wage differential. Professors of social work. Is this university exhibiting behavior associated with employer discrimination? Answer. If the law requires teachers in the same district to paid equally. to attract enough white teachers to fill the job slots. compensating white teachers for taking jobs they might otherwise find "distasteful"). also. the employer clearly prefers to hire men over women of comparable productive characteristics. Black teachers are equally willing to teach in both places. Because black teachers. central-city school district surrounded by white. Employer discrimination can be observed in two instances. Assume there is a predominantly black. may receive relatively low wages because the supply of labor to that field is greater relative to demand. with equal wages for men and women. are equally willing to work in central city or suburban schools when wages are equal. but white teachers are reluctant to take jobs in the central city (assume their prejudice extends only to students. Whatever the cause of the large relative supply of women to the social work field. the employer fails to hire an all-female work force. 4.between two productively equivalent groups) – so the facts quoted in the statement are not sufficient to determine if labor market discrimination is growing. or less than white teachers? Why? Answer. Wages in the suburban schools will be lower than the wages in central city schools. therefore. One occurs when. Because the university has apparently hired a nearly all-female work force in the School of Social Work. but allows salaries across districts to vary. these schools must attract white teachers who. The other occurs when. will black teachers earn more. Thus. not to black teachers). 72 . Because salaries for all teachers within a school district must be equal. by hypothesis. it does not seem to exhibit this latter behavior. There are different relative demands and supplies by academic field that are reflected in differential salaries. the black teachers in the central city schools must receive the higher wages there. You are involved in an investigation of charges that a large university in a small town is discriminating against female employees. Because there are too few black teachers to completely staff central city schools. suburban districts that recruit teachers from the same pool. prefer to teach in suburban schools.
. whose area is 4 x $2 x . then L = 20 workers for a profit-maximizing employer. Those who would have chosen to obtain training for skilled positions were not able to do so. Answer. of $2 per hour. where L = the number of lefthanded workers and MRPL is measured in dollars per hour. Answers to Even-Numbered Problems 2. Lost profits equal triangle ABC. Skilled white workers were helped. would have elected to obtain the training necessary for entrance to a skilled trade. Some unskilled whites.. Suppose that MRPL = 20 . 73 . The going wage for lefthanded workers is $10 per hour.5L. In the 1920s South Africa passed laws that effectively prohibited black Africans from working in jobs that required high degrees of skill.5L when profits are maximized. for which the wage was driven down still further by the requirement that blacks could not do other work.5L for left-handed workers.5 = $4 per hour. Blacks were crowded into low-paying unskilled occupations. A non-discriminating employer will hire left-handers until wage = MRPL. then L = 16 for employer A. The effects of the laws on white workers were ambiguous. Because 10 = 20 . reacting to the increased wage differential between skilled and unskilled jobs.. Graph the MRPL curve and show how many left-handed workers employer A hires. however. in the sense that they received higher wages than they would have received otherwise (had blacks been allowed into the skilled trades). How much profit has employer A lost by discriminating? Answer: See the figure. skilled jobs were reserved for whites. Unskilled whites. however. D. were probably made worse-off by this law because of its effects on the unskilled wage. The effects of the law on black Africans were unambiguously adverse. Employer A. Analyze the consequences of this law for black and white South African workers. however. but employer A discriminates against these workers and has a discrimination coefficient. Since 10 + 2 = 20 . will hire left-handers until wage + D = MRPL.8.
Ls = -45 + 5W and Ld = 180 – 10W. (Appendix) In the market for delivery truck drivers. set Ld = Ls and solve for W: -45 + 5W = 180 – 10W. The calculation for librarians is as follows: -15 + 5W = 180 – 10W. or 15W = 225. L = 30. employers would move back along the Ld curve from point A to point B on the figure below and hire fewer librarians. 74 . If the librarians' wage were increased to $15 per hour. where L = number of workers and W = wage in dollars per hour. 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. Ls = -15 + 5W and Ld = 180 – 10W. so W = $15 per hour Plugging this into the two equations shows that. so W = $13 per hour For librarians. for truck drivers. In the market for librarians.4. or 15W = 195. Answer: To find the equilibrium wage for truck drivers. Use a graph. L = 60. reducing their employment from 60 to 40.
their costs could go down now that there is no reason for paying a premium to workers 75 . Answer. Firms that engage in employer discrimination forgo profits in order to indulge their prejudices.Suggested Essay Questions 1. If customers are prejudiced. 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. or when consumers substitute other goods or services for the one in question). however. they will tend to avoid businesses hiring workers from groups they are prejudiced against. (It will. Answer. firms previously attracting prejudiced customers will lose business (either to firms that might not be covered by the law. profit-maximizing employers will prefer to hire workers from groups that customers do not have distaste for. 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.) 2. however. requiring them to hire and pay qualified minorities in proportion to their availability will not reduce profits. thus. reduce the utility owners derive from their businesses. If the law requires employers to hire from all groups proportionately. Thus.
76 .from “favored” groups. so their costs will rise. Firms previously attracting non-prejudicial customers will now be unable to capitalize on the lower demand (and lower wages) for minority workers.
unions are constrained by the demand for their members' services.CHAPTER 13 . Having analyzed some key characteristics of union behavior. We use this analysis to help understand the major trends in American unionization. The true (or absolute) effects of unions on wages are not measurable. in both the private and public sectors. The appendix to Chapter 13 analyzes how the uncertainty of arbitrators' decisions affects bargaining outcomes. and American union activities are relatively decentralized. We close the chapter by summarizing empirical evidence on the effects of unions on relative wages. Unions are constrained in their objectives by the labor demand curve. found by comparing union wages to wages in the nonunion sector. In attempting to explain the major activities of unions. the discussion defines and illustrates the concept of risk aversion. in which the union sets the wage and the employer adjusts by setting the employment level. before turning to elementary coverage of major pieces of labor legislation in the United States. As in the appendix to Chapter 8. and the possible biases inherent in measuring the absolute effects using relative-effect measures are discussed at length. The simplest model of unions' objectives is the "monopoly union" model.. In seeking their objectives. No discussion of union behavior would be complete without an analysis of strike activity and (for the public sector) interest arbitration. and discuss both "traditional" and alternative views of union effects on the overall social welfare. employment. 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. total compensation. in which the union and firm jointly bargain over wage and employment levels. and profit. Union membership as a fraction of the population in the United States is low relative to the other major industrial countries. The section on arbitration discusses the contract zone in the context of both conventional and final-offer arbitration. It begins with some necessary definitions and descriptions of unionism in the United States compared to elsewhere in the world.UNIONS AND THE LABOR MARKET The major focus of this chapter is on the economic effects of unions. we have organized the analysis around the demand for unions by workers and the supply of union services by labor unions. Unions facing relatively inelastic demand curves are better able to raise wages without adversely affecting employment levels very much. 77 . 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). 2. A more complex model is the "efficient contracts" model. List of Major Concepts 1. productivity.
it is not clear whether a wider contract zone increases or reduces the chances a dispute will go to arbitration. by reference to shifts in the demand and supply curves for union services (caused by the feminization of the work force." 12. competitive pressures. 6. they can also occur because. in part. 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). 5. Union leaders. Interest arbitration is used in the public sector. The Hicks bargaining model suggests when strikes will end. in the context of asymmetric information. Under this model. 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. and interest arbitration can be "conventional" or "final offer. 7. which is tripartite in nature. one party wants to elicit a signal from the other about its true preferences or constraints. Unions' propensities to strike vary over the business cycle and have trended down over time. The "efficient-contracts" model emphasizes that if unions and employers bargain only over wages. 8.3. However. The decline in American union membership can be understood. may pursue the twin goals of maintaining their positions in the union and educating union members by recommending a strike. where strikes are generally not permitted. but it does not explain why strikes occur in the first place. views union leaders and union members as sometimes having conflicting perspectives. The monopoly-union model assumes that the union sets the wage and the employer sets the employment level. regional shifts. the two parties bargain over both wage and employment levels. Strikes are intended to impose financial costs on employers if they do not agree to union offers. who have better information than their members. The Ashenfelter-Johnson model of strike activity. 4. 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. but because they also impose costs on employees. While strikes can occur because one party mistakes the other's true position. 78 . 11. 9. 10. both sides become more willing to make concessions as strike duration increases. and employer resistance). the resulting employment/wage outcome will be inferior to another set of outcomes that would improve the welfare of both parties. a change in industrial composition.
We can only measure union wages relative to nonunion wages. If employers raise wages in the nonunion sector to keep unions out (thus creating unemployment in that sector). restrictive work practices. In an overall sense. and largest among unskilled (and minority) workers. 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. The traditional view of union effects stresses the social loss caused by inequality in wages (and marginal productivities) among workers of comparable skill. 20. in the United States. 15.13. thus. however. has an ambiguous effect on productivity. The traditional view also stresses the losses associated with union staffing requirements. larger in the United States than elsewhere. Union effects on employee benefits as a percentage of total compensation tend to be positive. the total compensation effects of unions may be greater than the relative wage effects. 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. unionization reduces employment or employment growth. the relative wage effect is smaller than the absolute union wage effect. Improved communications between labor and management may also increase productivity and worker motivation directly. 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. 21. 17. These wage effects are larger in the private than the public sector. If the nonunion labor market is in equilibrium. 19. and a negative effect on profits. unions appear to raise the wages of their members above the nonunion wage by something like 10 to 20 percent. Empirical evidence tends to suggest that. 18. The compensation advantages enjoyed by union members. 16. and strikes. measuring this absolute wage advantage is impossible. but employer resistance to 79 . 14. 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). 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. more hazardous and less flexible work settings in unionized firms. 22. however. may be in part a compensating wage differential for the more structured. but this is not a good measure of the absolute effect because the presence of unions alters the nonunion wage also.
Using economic theory. 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. 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. Under what conditions will a union standards clause most likely be sought by a labor union? Answer. (Appendix) When collective bargaining impasses can be decided by arbitration. 23. What is the union's rationale for seeking a union standards clause? b. Moreover. is to raise wages while preserving employment (or at least not having to undergo large employment declines). employers are not adding to their capital stock or opening new plants. However. how can this pattern be explained? Answer. if the product demand curve is relatively inelastic (so that scale effects are small). 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. and therefore more sought-after. Analogously. Likewise. The 80 . (b) The ultimate goal of the union. a. Answers to Even-Numbered Review Questions 2. 4. which will mitigate the amount of capital/labor substitution that might otherwise accompany a union standards clause. so technological improvements that substitute capital for labor are not easily made.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 successful in preserving employment. any tendency to substitute capital for labor will be met with a rising price of capital. 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. 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. 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. When output is contracting. when output is contracting. (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. of course. if the supply of capital to the firm is relatively inelastic.
each worker would face a 10 percent decrease in expected wages. assuming that its collective bargaining agreement with the city specifies that any layoffs will occur among those teachers most recently hired. 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. (a) If layoffs occur only among the most recently hired. society’s output could be increased if some moved from the low. or any other teacher characteristics. Is the following statement true. then each union member has a 10 percent chance of being laid off if salaries are held constant. Alternatively. b. Answer. compared to the case in which layoffs are made among those most recently hired. 90 percent of all union members will know that they will not be laid off. (b) If layoffs are to be made randomly. it is possible for each union worker to calculate whether he or she is among the group to be laid off. 81 . because even if wages rise the substitution of capital for labor may not take place. The traditional view is that when workers of comparable potential are in jobs with different productivities. Predict and explain the union's decision.” for example). it is much more likely that the union would choose to accept salary cuts than cuts in employment. 8.” Explain your answer. Therefore. please answer the following: a. in advance of the decision that must be made by the union. although they probably would if their workers were risk averse. 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 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. 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. teaching field. they may enhance society’s total output. A simple political model of union decision making could not predict for sure that unions would accept salary cuts 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).reduced ability to substitute capital for labor serves to strengthen the union’s hand.to the high-productivity jobs. In this case. Answer. 6. However. and 10 percent know for sure that they will be. Because the union leaders who had to make this decision are elected by majority rule. However. In either case. the chances of the union's deciding to accept employment cuts are much lower. false. if unions solve problems created by market imperfections (workers can use “voice” rather than “exit. Given that union leaders are elected by the membership. members could accept a 10 percent cut in their salaries with the assurance that they would not be laid off. independent of seniority.
thus employment will fall by only 2 percent if they boost wages by 20 percent. Clearly. under which wage bargains are applied nationally. 2. therefore. and these workers will be worse off if the boycott lasts and is successful. and abroad. the scale of output will fall owing to the boycott.1 = %(quantity demanded)/20%. given their preferences and opportunities.S. A certain country has very centralized collective bargaining. selling. In the case of the Brain Surgeons this implies -0. 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. but have no power to directly set employment levels. If so. Boycotting goods made by workers in “sweatshop” conditions. then. Thus. Answer. some workers. we must also consider the scale effects associated with higher costs overseas. (b) Will they unambiguously help the union’s American workers? Explain fully. The Dog Catcher's International faces an own-wage elasticity of demand for its labor that equals -3. (a) If successful. the demand for American labor may rise. we would expect that consumers would tend to substitute American goods (now relatively cheaper) for foreignmade goods.Answers to Even-Numbered Problems 2. output price will tend to rise and only those consumers willing to pay the higher prices will remain in the market. This country is thinking about adopting a bargaining 82 . tends to reduce demand (because of both scale and substitution effects) for the services of low-wage labor.1. However. distributing) that depend on the scale of output produced both in the U. (b) If manufactured items from abroad become more expensive. 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). when the costs of foreign labor rise.0. The Brain Surgeon's Brotherhood faces an own-wage elasticity of demand for its labor that equals -0. 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. and if this substitution effect is dominant. Suppose that leaders in both unions push for a 20 percent wage increase. Some American workers may have jobs (in packaging. thus employment will fall by 60% if they boost wages by 20 percent. In the case of the Dog Catchers this implies -3 = %(quantity demanded)/20%. Suggested Essay Questions 1. the will be gross substitutes. may be gross complements with foreign workers. foreign and American workers may be considered substitutes in production. and the costs of producing the items in question will rise. (a) If manufacturers in these less developed countries are induced to raise wages and improve working conditions. will these efforts unambiguously help the targeted foreign workers? Explain fully.
Overall. and they may moderate their demands as a result. and less in other. wage increases will be greater than what they would have been under centralized bargaining in some sectors. A national union may perceive the product demand (and hence labor demand) of employers to be relatively inelastic. 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. with centralized bargaining. because if it is able to raise wages in all sectors. a greater ability to tailor local demands to local elasticities should result in a reduced level of job loss associated with unionization. while those with elasticities less than the national aggregate would bargain for less. where elasticity is higher. however. consumers have limited incentives for substituting goods from one sector for goods from another. however. and employment losses to be larger. so that wage bargains will be made at the individual plant or firm level. How would you expect decentralization to affect wages and employment? Explain why. we might expect wage increases to be larger. At a more disaggregated level. 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. 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 broad level of analysis. Union power to raise wages is affected by the elasticity of demand for its workers.structure that is more decentralized. Answer. Thus. When bargaining is very decentralized. Thus. 83 .
Earnings also became more dispersed within human-capital groups. but only for the less-educated. The appendix discusses the derivation of Lorenz curves and Gini-coefficients. and earnings dispersion within narrowly-defined human capital groups. The underlying causes of growing inequality are then grouped into supply factors. 4. 5.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. The most notable change in earnings for both men and women was the increase in the relative earnings of more-educated workers. or labor demand changes. 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 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). and this dispersion can be measured in various ways. institutional changes. The returns to experience rose modestly.CHAPTER 14 . which differ in the ease with which they can be completed and widely understood. and demand-side influences. Growing disparities could result from labor supply. institutional. Earnings inequality is a function of the dispersion of the earnings distribution. Earnings distributions for both men and women became "stretched" in the 1980s. leading to increased relative demand for educated workers). 84 . Empirical studies are surveyed. hours of work. while for women it was associated mainly with the increased real earnings of more-educated women. 8. 3. 6. for men this increase occurred mainly because earnings of the less-educated fell in real terms. 2. List of Major Concepts 1. relative wages. 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. Changes in the relative hours of work played no role in the growth of inequality. with the conclusion that demand factors were dominant in the 1980s (especially computerrelated technological changes that affected the mix of productive factors. 7.
In summary. there may be offsetting tendencies. The remedy will not apply to small firms. but they apparently played a minor one. but the jobs to which it will apply are among the lowest-paying jobs. women in the very lowest part of the income distribution might experience wage reductions. Thus. while those slightly above them will experience wage increases. but because the remedy applies only to the highest-paying firms. (For a review of relevant concepts. Assuming that more highly paid workers have higher employee benefits. 4. 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. the more dominant of these two tendencies is difficult to forecast. In particular. 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. see Chapter 8. 11. (For a review of relevant concepts. which are not now subject to the income tax. with the latter changes the dominant force in the growth of education-related differentials. Such institutional factors as a "frozen" minimum wage and declining unionization could have played a role in the 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.) 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. The growth of contingent-pay plans might underlie the increased dispersion within human-capital groups. 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. (Appendix) The Lorenz curve and Gini coefficient are related measures of disparities that are based on groups' shares among the total. 12. Raising the wages of the lowest-paying jobs will tend to equalize the distribution of earnings. analyze the effects on earnings inequality if these tax proposals are adopted. Proposals to tax health and other employee benefits. 10. but definitive work has yet to be done. see Chapter 12. The reason is that the employers to which the comparable worth remedy will apply are the highestpaying employers. 13. Answers to Even-Numbered Review Questions 2.9. Given what you learned earlier about wages by firm size and in female-dominated jobs. have been made in recent years.) 85 . Both product demand changes and changes in the mix of productive factors contributed to growing inequality.
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. see Chapter 10. Thus. owing to the increased taxes paid by highly-compensated workers. Assuming overall (pre-tax) compensation levels are not changed by this new law. 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. while reducing employment to 20.Answer: If employee benefits are subjected to the income tax. Answers to Even-Numbered Problems 2. (The distribution of post-tax compensation. is more equal than before. with the result that the overall distribution of total pre-tax compensation might remain essentially unchanged. 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. at least in the long-run. a response to earnings inequality across geographic areas. where wages fall to $4. Has wage inequality risen or fallen? Explain.) Answer: Geographic mobility is. Displaced workers in sector B move into sector C. the receipt of compensation in the form of "in-kind" or deferred benefits becomes less attractive. is offset by a narrowing of the dispersion of employee benefits received. Suppose that the wage distribution for a small town is given below.50 per hour as employment grows to 30. geographic mobility should tend to equalize earnings across areas -. its main effect will be to shift the compensation of highlypaid workers away from benefits and toward even higher levels of cash earnings. the covered sector. Widening the dispersion of earnings. however.) 6. however. then the effect of this benefits tax will be to widen the dispersion of earnings in society. (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. People tend to move from areas with low opportunities (wages) to places where they believe they can improve their earnings. at least in part. but boosts wages to $7 per hour in sector B. 86 .driving up wages in low-wage areas (as workers move out) and driving down wages in high-wage areas.
technological change does not imply anything about changes in wage equality. the share of income going to the bottom half of the income distribution has risen (from $250/$750 = . Technological change will increase real incomes in both countries. the 80th-20th percentile wage ratio has risen (from $10/$5 = 2 to $10/$4.355). an 80-20 measure would show improvement. For example. depending on the ratio of marginal product to wages for the two kinds of workers in X and Y (clearly. and different results could be obtained by different measures. Suggested Essay Questions 1.) 2. 87 . while those who are uncovered are at the 10th. X and Y now agree to drop these tariffs. they have levied tariffs on each other’s exports. Historically. (Of course. As discussed in Chapter 4 and its appendix. 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). and less of another. On the one hand. Would a higher minimum wage promote more wage equality? Discuss thoroughly. 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. In this case. On the other hand. Answer. which can now take advantage of cheaper goods and services.22). one possible effect of a higher minimum wage is for the “spillover effect” to cause lower wages in the uncovered sector. but fall for others – and the effects on wage inequality are ambiguous.Answer: There are several ways to measure inequality. Countries X and Y both have agricultural and industrial sectors. wages rise for some low-wage workers. but a 90-10 measure would indicate greater inequality. there are different ways of measuring wage inequality. Comparative advantage may call for more of one kind of worker in a given country to be used. thus wage inequality has fallen by this measure. these sectoral shifts do not depend on wage levels alone). However. which have had the effect of reducing trade between the two countries. As discussed in Chapter 4. There is no unambiguous answer to this question.50 = 2. if workers covered by a new minimum wage were at the 20th percentile of the wage distribution.333 to $275/$775 = .
In the section on frictional unemployment we discuss search theory and the effects of unemployment benefits on job search. it remains a useful indicator of labor market conditions. Frictional unemployment occurs because labor market information is imperfect. It takes time even in the best of markets for unemployed workers and employers with job vacancies to find each other. 5. 2. this stock is constantly changing. Thus. Thus.UNEMPLOYMENT This chapter defines the unemployment rate and discusses its strengths and weaknesses as a measure of economic welfare. the longer unemployed workers will tend to search for jobs. the more generous these benefits are. government policies. and we then discuss effects of the changing age. List of Major Concepts 1. different demographic groups may have different unemployment rates because of different propensities to quit or be laid off from jobs. As these flows change relative to each other. new hires and recalls. demand deficient. and efficiency wages (including the "wage curve") are discussed. there is an underlying set of flows into and out of that stock. Further. more generous 88 . the unemployment rate changes in predictable ways. 3. The section on demand deficient unemployment analyzes wage rigidity. focusing only on the stock masks the highly dynamic nature of labor markets. occupational and geographical imbalances. we discuss four general types of unemployment: frictional. While one can think of a stock of unemployed persons. and sex composition of the labor force on the full employment rate of unemployment. Unemployment rates are affected by layoffs and quits. and seasonal unemployment. Since the receipt of unemployment insurance benefits reduces the costs of extra time spent searching for work. The chapter also treats the issue of "full employment. 4. and the extent to which someone will spend time searching for work depends upon the expected benefits and costs of continuing search. Government efforts to improve the rapidity of the job-matching process could reduce the extent of frictional unemployment. it emphasizes that while the unemployment rate is a stock concept. A period of unemployment can be looked upon as a period when job search can be undertaken. and policies and adjustments found in Europe. The unemployment rate is the number of nonemployed people seeking work divided by the number of people who are in the labor force.CHAPTER 15 . When analyzing structural unemployment. the financing of unemployment benefits. race. structural. While this measure has a number of serious drawbacks. Next. retirees from and new entrants into the labor market." The structure of unemployment rates across demographic groups is presented.
. 10. including the preference of unions for layoffs over wage cuts. Answers to Even-Numbered Review Questions 89 . 12. when the risk of layoff is high. 8. but it is also affected by downward rigidity of money wages and the government's unemployment insurance program. 9. teenagers. There are several reasons for the downward inflexibility of money wages. Government efforts to subsidize mobility and/or job training would serve to reduce the incidence of structural unemployment.e. and implicit contractual agreements that after an initial period. 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. cyclical fluctuations in labor demand are more likely to be manifest in adjustments in hours. not employment levels. 13. Demand-deficient unemployment occurs when the aggregate demand for labor declines in the face of downward inflexibility of nominal or real wages. 14. the asymmetry of information between employers and employees. Seasonal unemployment may be associated with changes in the weather or with model changeovers. in part due to the changing proportion of women. risk aversion of older workers. yearly earnings of workers will stabilize. 7. firm-specific training. 11.unemployment insurance benefits may be expected to increase the duration of unemployment. this curve plots a negative relationship between the regions' wage rates and their unemployment rates. concerns about status. One reason for the greater adjustments in hours of work may lie in the wider use of partial unemployment compensation benefits in Europe. and ethnic minorities in the labor force. The full-employment rate of unemployment (i. Structural unemployment is also associated with firms' decisions to pay efficiency wages.defined by skill or geography -. in such cases. some workers without jobs "wait" for jobs in the high-paying sector and do not seek jobs in lower-paying firms. In Europe. unemployment in "normal" times) appears to have changed in recent years.are impeded. Efficiency wages may underlie the "wage curve" found in almost all countries studied. Structural unemployment occurs when flows of workers into and out of particular labor markets -. 6.
this policy will probably reduce unemployment associated with demand deficiency. 4. a policy of raising UI benefit levels is not socially desirable. It does not distinguish between unemployment of a skilled adult and unemployment of an unskilled new entrant into the labor force. From an efficiency perspective. Answer. however. In the 1970s Sweden adopted several new labor market policies affecting layoffs. There are many problems with using the aggregate unemployment rate as an indicator of labor market tightness. It tells us nothing about the number of workers who are employed. If the training that is subsidized is useful and geared to market demands. It is consistently measured over time. What probable effects would these policies. then the substitution of training periods for periods of unemployment may 90 . The social desirability of raising unemployment insurance (UI) benefits depends on a number of factors. have on wages. the costs of higher UI benefits are the prolonged spells of unemployment they induce (they encourage unemployed workers to search longer). Government officials find it useful to measure the nation's "economic health." Explain your answer. employment. like the unemployment insurance system. (2) All workers had to be given at least one month's notice before being laid off. If individuals find higherpaying jobs that match their skills more closely. false. It provides no information about the number of individuals who are not actively searching for work because they were unsuccessful in the past. The benefits of higher UI benefits are the better job matches they induce. so that – despite its weaknesses – we can measure changes in labor market conditions from one year to the next. output will increase and the probability that these workers will quit their jobs in the future will decline.2. Three were notable: (1) Plants that provided in-plant training instead of laying off workers in a recession received government subsidies. Policy number one clearly increases the incentives of firms to retain workers during a recession. It tells us nothing about whether the employed are working at jobs commensurate with their skill levels. Finally. it is sensitive to the generosity of some social programs. taken as a whole. 6. as they provide unemployed workers with the resources to continue to search for jobs more commensurate with their skill levels. Is the following assertion true. and unemployment in the long run? Answer. and the required time in the average plant was two to three months. Hence. Do you think the unemployment rate is a useful indicator of labor market tightness? Answer. Therefore." The unemployment rate is currently used as a major indicator of the relative strength of labor supply and demand. (3) Laid-off workers had to be given first option on new jobs with the former employer. The empirical magnitudes of these various effects must be evaluated before one can decide if it is desirable to raise UI benefits. or uncertain? "Increasing the level of unemployment insurance benefits will prolong the average length of spells of unemployment.
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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