Chapter 13 - Wage Determination

Chapter 13 - Wage Determination
Chapter 13 Wage Determination
QUESTIONS
1. Explain why the general level of wages is high in the United States and other industrially
advanced countries. What is the single most important factor underlying the long‐run increase in
average real‐wage rates in the United States? LO1
Answer: The general level of wages is higher in the United States and other industrially
advanced nations because of the high demand for labor in relation to supply. Labor
productivity is high in the U.S and other industrially advanced countries because: (1)
capital per worker is very high; (2) natural resources are abundant relative to the size of
the labor force particularly in the U.S.; (3) technology is advanced in the United States
and other industrially advanced countries relative to much of the rest of the world; (4)
labor quality is high because of health, vigor, training, and work attitudes; (5) other
factors contributing to high American productivity are the efficiency and flexibility of
American management; the business, social, and political environment that greatly
emphasizes production and productivity; and the vast domestic market, which facilitates
the gaining of economies of scale.
2. Why is a firm in a purely competitive labor market a wage taker? What would happen if it
decided to pay less than the going market wage rate? LO2
Answer: A firm in a purely competitive labor market is a wage taker because there are a
large number of firms wanting to buy the labor services of the workers in that market and
a large number of workers with identical skills wanting to sell their labor services. As a
result, the individual firm has no control over the price of labor.
If a firm attempted to pay a wage below the going wage, no workers would offer their
services to that firm.
3. Describe wage determination in a labor market in which workers are unorganized and many
firms actively compete for the services of labor. Show this situation graphically, using W1 to
indicate the equilibrium wage rate and Q1 to show the number of workers hired by the firms as a
group. Show the labor supply curve of the individual firm, and compare it with that of the total
market. Why the differences? In the diagram representing the firm, identify total revenue, total
wage cost, and revenue available for the payment of non-labor resources. LO2
Answer: The labor market is made up of many firms desiring to purchase a particular
labor service and of many workers with that labor service. The market demand curve is
downward sloping because of diminishing returns and the market supply curve is upward
sloping because a higher wage will be necessary to attract additional workers into the
market. Whereas the individual firm’s supply curve is perfectly elastic because it can
hire any number of workers at the going wage, the market supply curve is upward
sloping.
For the graphs, see Figure 13.3 and its legend.
13-1
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4. Suppose the formerly competing firms in question 3 form an employers’ association that hires
labor as a monopsonist would. Describe verbally the effect on wage rates and employment.
Adjust the graph you drew for question 3, showing the monopsonistic wage rate and employment
level as W2 and Q2, respectively. Using this monopsony model, explain why hospital
administrators sometimes complain about a “shortage” of nurses. How might such a shortage be
corrected? LO3
Answer: The equilibrium wage in the monopsonistic market declines from the
competitive market’s Wl rate to W2. The employment level in this market will decline
from Q1 to Q2. See Figure 13.4 (wage falls from Wc to Wm and the employment level
falls from Qc to Qm).
If there are only one or two hospitals in an area, there exists a monopsonistic market for
nurses. Their wages would be less than those for nurses where there is competition
among employers (numerous hospitals and/or clinics). Because hospitals prefer to hire
more nurses at a wage W2, they view the difference between Q3 and Q2 as a shortage.
However, since their profits are maximized at W 2, they are unwilling to raise wages
voluntarily. The hospital administrator might offer a higher wage, but this wage would
not be profit maximizing. Another solution would be for nurses to organize and demand
higher wages. This would allow nurses to earn wages closer to their MRP and as wages
rise toward W1, the shortage would disappear.
5. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as

indicated in Figure 13.8. Now suppose an industrial union is formed that forces the employer to
accept a wage rate of Wc. Explain verbally and graphically why in this instance the higher wage
rate will be accompanied by an increase in the number of workers hired. LO4
Answer: The union wage rate Wc becomes the firm’s MRC, which would be shown as a
horizontal line to the left of the labor supply curve. Each unit of labor now adds only its
own wage rate to the firm’s costs. The firm will employ Qc workers, the quantity of
labor where MRP = MRC (= Wc); Qc is greater than the Qm workers it would employ if
there were no union and if the employer did not have any monopsonistic power, i.e., more
workers are willing to offer their labor services when the wage is Wc than Wm.
6. Have you ever worked for the minimum wage? If so, for how long? Would you favor
increasing the minimum wage by a dollar? By two dollars? By five dollars? Explain your
reasoning. LO5
Answer: Student answers will vary. Those students that have worked for minimum wage
probably didn’t stay at that job for long, and would probably describe their performance
and that of their co-workers as relatively unproductive (an absence of efficiency wages).
Support for an increase will depend on factors such as their perception of how much
employment would be lost versus the income gains of those retaining employment.
13-2
whole or part.
7. “Many of the lowest‐paid people in society—for example, short‐order cooks— also have
relatively poor working conditions. Hence, the notion of compensating wage differentials is
disproved.” Do you agree? Explain. LO5
Answer: Short-order cooks generally need few specific skills, i.e., practically anyone is
thought to be capable of flipping burgers. Since the supply of unskilled workers is high
relative to the demand for them, their wages are low. In this case, the concept of
compensating wage differentials is swamped by the excess supply of low-wage workers.
8. What is meant by investment in human capital? Use this concept to explain (a) wage
differentials and (b) the long‐run rise of real wage rates in the United States. LO5
Answer: Investment in human capital is educational activity that improves individual

productivity
(a) Wage differentials are explainable to some extent through the concept of human
capital investment. There is a strong positive correlation between time spent
acquiring a formal education and lifetime earnings. Of course, it can be said that the
brain surgeon who spent over twenty years in training, starting in grade 1, had the
qualities to succeed in the labor market without spending over twenty years in school.
Though this counter-argument has some merit, the point still is that this highly-
skilled individual would never have become a brain surgeon without the over twenty
years in school and might not have achieved the particular high income that goes
with being a medical specialist.
(b) The long-run rise in real wage rates in the United States is positively correlated to
investment in human capital. Without the increase in education and training of the
American labor force that has occurred over the years, productivity (output per
person per hour) would still have risen because of the investment in real capital,
improved technology, and our abundant natural resource base. But the real wage
would undoubtedly now be very much lower, because an unskilled labor force could
not possibly have made efficient use of the material resources and advancing
technology of the economy.
9. What is the principal‐agent problem? Have you ever worked in a setting where this problem
has arisen? If so, do you think increased monitoring would have eliminated the problem? Why
don’t firms simply hire more supervisors to eliminate shirking? LO6
Answer: Business owners who hire workers because they are needed to help produce the
goods or services of the firm face the dilemma of the principal-agent problem. Workers
are the agents; they are hired to promote the interests of the firm's owners (the
principals). Owners and workers both have a common goal in the survival of the firm,
but their interests are not identical. A principal- agent problem arises when those
interests diverge. Workers may seek to increase their utility by shirking their
responsibilities and providing less than the agreed upon effort. Owners of firms have a
profit incentive to reduce or eliminate shirking. Hiring more supervisory personnel can
be costly and there is no guarantee that it will eliminate the problem.
13-3
whole or part.
10. LAST WORD Do you think exceptionally high pay to CEOs is economically justified? Why
or why not?
Answer: Student answers will vary. Supporters will point to the important decisions
made by CEOs and their effect on overall firm productivity. High pay provides an
incentive not only for current CEOs, but also for aspiring CEOs, further enhancing
productivity. Critics argue that while pay gaps are necessary, they are excessive relative
to the productivity differences. They further argue that stockholders are hurt because
high CEO pay reduces company profits.
PROBLEMS
1. Workers are compensated by firms with “benefits” in addition to wages and salaries. The most
prominent benefit offered by many firms is health insurance. Suppose that in 2000 workers at one
steel plant were paid $20 per hour and in addition received health benefits at the rate of $4 per
hour. Also suppose that by 2010 workers at that plant were paid $21 per hour but received $9 in
health insurance benefits. LO1
a. By what percentage did total compensation (wages plus benefits) change at this plant from
2000 to 2010? What was the approximate average annual percentage change in total
compensation?
b. By what percentage did wages change at this plant from 2000 to 2010? What was the
approximate average annual percentage change in wages?
c. If workers value a dollar of health benefits as much as they value a dollar of wages, by what
total percentage will they feel that their incomes have risen over this time period? What if they
only consider wages when calculating their incomes?
d. Is it possible for workers to feel as though their wages are stagnating even if total
compensation is rising?
Answers: (a) Total compensation rose from $24 in 2000 to $30 in 2010. This is a 25%
increase. Dividing that number by 10 we see that the average annual growth rate was
approximately 2.5% per year. (b) Wages went up by 5% over this time period (= $1/$20).
Dividing that number by the number of years (10), we see that the approximate average
annual growth rate of total compensation was 0.5% per year. (c) If workers value health
benefits as much as wages, then they will feel that their incomes have risen by 25%. If they
exclude health benefits and focus only on wages, they will feel that their incomes went up
5%. (d) Yes, this is possible. See answers to part c.
Feedback: Consider the following example: Suppose that in 2000 workers at one steel
plant were paid $20 per hour and in addition received health benefits at the rate of $4 per
hour. Also suppose that by 2010 workers at that plant were paid $21 per hour but received
$9 in health insurance benefits.
Part a:
Total compensation in 2000 was $24 (=$20 (wage rate) + $4 (health benefits)) and in
2010 total compensation is $30 (=$21 + $9).
The percentage increase in total compensation is (30-24)/24 = 6/24 = 0.25 (or 25%). This
implies the approximate average annual percentage change in total compensation is
0.25/10 = 0.025 (or 2.5%).
13-4
whole or part.
Part b:
The percentage increase in wages alone is (21-20)/20 = 1/20 = 0.05 (or 5%). This implies
the approximate average annual percentage change in wages is 0.05/10 = 0.005 (or
0.5%).
Part c:
If workers value a dollar of health benefits as much as they value a dollar of wages, they
feel that their incomes have risen by 25% (part a) over this time period.
If they only consider wages when calculating their incomes they feel that their incomes
have risen by 5% (part b) over this time period.
Part d:
Yes, if workers only look at their wages they may feel as if their wages are stagnating.
2. Complete the following labor supply table for a firm hiring labor competitively:
LO2
a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Are
the curves the same or different? If they are different, which one is higher?
b. Plot the labor demand data of question 2 in Chapter 12 on the graph used in part a above. What
are the equilibrium wage rate and level of employment?
Answers: (a) The supply curve and the MRC are the same.
Total Marginal
Units Wage labor cost resource
of labor Rate (labor) cost
0 $14 $0
$14
1 14 14
14
2 14 28
14
3 14 42
14
4 14 56
14
5 14 70
14
6 14 84
13-5
whole or part.
(b)
Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor.
Feedback: Consider the following example (Table):
13-6
whole or part.
(a) The labor supply curve and MRC curve coincide as a single horizontal line at the
market wage rate of $14. The firm can employ as much labor as it wants, each unit
costing $14; wage rate = MRC because the wage rate is constant to the firm.
Total Marginal
of labor Rate (labor) cost
0 $14 $0
$14
1 14 14
14
2 14 28
14
3 14 42
14
4 14 56
14
5 14 70
14
6 14 84
(b) Graph: equilibrium is at the intersection of the MRP and MRC curves. Equilibrium
wage rate = $14; equilibrium level of employment = 5 units of labor. From the
tables: MRP exceeds MRC for each of the first four units of labor, MRP = MRC for
the fifth unit, and MRP is less than MRC for the sixth unit.
Table from question 2, Chapter 12:
13-7
whole or part.
Units Marginal
of Total Marginal Product Total revenue
labor product product price revenue product
0 0 $2 $0
1 17 17 2 34 $34
2 31 14 2 62 28
3 43 12 2 86 24
4 53 10 2 106 20
5 60 7 2 120 14
6 65 5 2 130 10
3. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage
rate by $3 to attract each successive worker (so that the second worker must be paid $9, the third
$12, and so on). LO3
a. Draw the firm’s labor supply and marginal resource cost curves. Are the curves the same or
different? If they are different, which one is higher?
b. On the same graph, plot the labor demand data of question 2 in Chapter 12. What are the
equilibrium wage rate and level of employment?
c. Compare these answers with those you found in problem 2. By how much does the
monoposonist reduce wages below the competitive wage? By how much does the monopsonist
reduce employment below the competitive level?
Answers: (a) Graph: (approximate shape below. Also note that the discreet nature of the
problem requires that the marginal revenue product (MRP) be greater than or equal to the
marginal resource cost (MRC)):
13-8
whole or part.
MRC monopsony
MRP = $24
MRC = $18 Supply monopsony
competitive wage = $14 MRC=Supply competitive
monopsony wage = $12
MRP
$6
1 3 5
units of labor
The curves are different; the MRC curve is higher than the labor supply curve.
(b) The firm will employ three workers in this situation. Here the MRP = $24 is greater than
the MRC = $18. For the fourth worker the MRP = $20 and the MRC = $24.
(c) The monopsonist reduces the wage by $2 (from $14 to $12) and reduces employment by
two workers (from 5 to 3).
Feedback: Consider the following example: Assume a firm is a monopsonist that can
hire its first worker for $6 but must increase the wage rate by $3 to attract each
successive worker (so that the second worker must be paid $9, the third $12, and so on).
Parts a and b:
Table for part a and table for part b (from question 2 in Chapter 12 and problem 2 above).
Total Marginal
of labor Rate (wage bill) (labor) cost
0 $NA $0
$6
1 6 6
12
2 9 18
18
3 12 36
24
4 15 60
30
5 18 90
36
6 21 126
13-9
whole or part.
Units Marginal
of Total Marginal Product Total revenue
labor product product price revenue product
0 0 $2 $0
1 17 17 2 34 $34
2 31 14 2 62 28
3 43 12 2 86 24
4 53 10 2 106 20
5 60 7 2 120 14
6 65 5 2 130 10
Graph: (approximate shape below. Also note that the discreet nature of the problem
requires that the marginal revenue product (MRP) be greater than or equal to the marginal
resource cost (MRC)).
MRC monopsony
MRP = $24
MRC = $18 Supply monopsony
competitive wage = $14 MRC=Supply competitive
monopsony wage = $12
MRP
$6
1 3 5
units of labor
The MRC schedule lies above the labor supply schedule because employing the next
worker requires a higher wage in this market and you must pay all workers this higher
wage.
13-10
whole or part.
The firm will employ three workers in this situation. To see this look at the MRP and
MRC columns in the table above. The first worker will generate a MRP = $34 and will
have a MRC = $6, thus the firm will employ this worker (the marginal revenue product
for this worker is greater than his or her marginal cost). For the second worker we have
MRP = $28 and MRC = $12, so we employ this worker. For the third worker we have
MRP = $24 is greater than the MRC = $18, so we employ this worker as well. For the
fourth worker we have MRP = $20 and the MRC = $24. In this case the marginal cost of
this worker is greater than the worker's marginal revenue product, so we do not employ
this worker.
Part c: The monopsonist decreases employment by 2 units and the equilibrium wage rate
is $2 less than the competitive wage.
4. Suppose that low‐skilled workers employed in clearing woodland can each clear one acre per
month if they are each equipped with a shovel, a machete, and a chainsaw. Clearing one acre
brings in $1000 in revenue. Each worker’s equipment costs the worker’s employer $150 per
month to rent and each worker toils 40 hours per week for four weeks each month. LO4
a. What is the marginal revenue product of hiring one low‐skilled worker to clear woodland for
one month?
b. How much revenue per hour does each worker bring in?
c. If the minimum wage were $6.20, would the revenue per hour in part b exceed the minimum
wage? If so, by how much per hour?
d. Now consider the employer’s total costs. These include the equipment costs as well as a normal
profit of $50 per acre. If the firm pays workers the minimum wage of $6.20 per hour, what will
the firm’s economic profit or loss be per acre?
e. At what value would the minimum wage have to be set so that the firm would make zero
economic profit from employing an additional low‐skilled worker to clear woodland?
Answers: (a) $1000. (b) $6.25 (= $1000/160 hours). (c) Yes, exceeds by $0.05 per hour. (d)
The firm’s loss per acre will be -192.00 dollars (= $1000 in revenue - $150 in rental cost for
equipment - $50 in normal profit - $992 in wages for 160 hours at $6.20 per hour). (e) If X is
the firm’s labor cost per worker for one month to clear one acre, then we need $1000 - $150
- $50 – X = 0. Solving this equation for X yields X = $800. Dividing X by 160 hours yields a
minimum wage of $5 per hour as what would be needed for the firm to earn zero profit.
Feedback: Consider the following example. Clearing one acre brings in $1000 in
revenue. Each worker’s equipment costs the worker’s employer $150 per month to rent
and each worker toils 40 hours per week for four weeks each month.
Part a: The marginal revenue is $1000. This is the revenue each worker can generate for
the firm by clearing one acre.
Part b: Since the worker generates $1000 per month and works a total of 160 hours (40
hours per week for 4 weeks), revenue per hour equals $6.25 (= $1000/160).
Part c: If the minimum wage were $6.20, revenue per hour in part b exceeds the
minimum wage by 5 cents per hour (=$6.25-$6.20).
13-11
whole or part.
Part d: Now consider the employer’s total costs. These include the equipment costs as
well as a normal profit of $50 per acre. The total explicit cost for the firm per acre equals
$150. Thus, the economic profit per worker at the minimum wage equals $1000
(revenue) - $150 (explicit cost) - $50 (normal profit) - 160x$6.20 (hour of labor
multiplied by the minimum wage = $992) = -$192. The firm suffers a loss per acre.
Part e: To determine the minimum wage necessary for the firm to break-even (earn zero
economic profit, we first calculate the revenue left over for labor after accounting for
normal profit and explicit cost. The revenue left over after these components have been
removed is $800 (=$1000 - $150 -$50). This leaves $800 left to pay each unit of labor for
the month (clears one acre). Since each worker works 160 hours a month, the highest the
break-even wage can be is $5 (=$800/160). This is the highest the minimum wage can be
set in the industry without exit.
5. Suppose that a car dealership wishes to see if efficiency wages will help improve its
salespeople’s productivity. Currently, each salesperson sells an average of one car per day while
being paid $20 per hour for an eight‐hour day. LO6
a. What is the current labor cost per car sold?
b. Suppose that when the dealer raises the price of labor to $30 per hour the average number of
cars sold by a salesperson increases to two per day. What is now the labor cost per car sold? By
how much is it higher or lower than it was before? Has the efficiency of labor expenditures by the
firm (cars sold per dollar of wages paid to salespeople) increased or decreased?
c. Suppose that if the wage is raised a second time to $40 per hour the number of cars sold rises to
an average of 2.5 per day. What is now the labor cost per car sold?
d. If the firm’s goal is to maximize the efficiency of its labor expenditures, which of the three
hourly salary rates should it use: $20 per hour, $30 per hour, or $40 per hour?
e. By contrast, which salary maximizes the productivity of the car dealer’s workers (cars sold per
worker per day)?
Answers: (a) $160 (b) $120 per vehicle; $40 less per vehicle; increased. (c) $128 per vehicle.
(d) $30 per hour (e) $40 per hour.
Feedback: The current labor cost per car is $160 (= $20 per hour times eight hours per
day divided by 1 car sold per day on average). (b) The labor cost per hour falls to $120
per vehicle. It is now $40 less per vehicle. Efficiency has increased. (c) The labor cost per
car is now $128 per vehicle. (d) The dealer should pay $30 per hour if it wants to
maximize the efficiency of labor expenditures. (e) If the dealer wants to maximize output
per worker per day, it should pay $40 per hour.
13-12
whole or part.

Chapter 13 - Wage Determination

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Chapter 13 - Wage Determination

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Chapter 13 - Wage Determination

Chapter 13 Wage Determination

5. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as

Answer: Investment in human capital is educational activity that improves individual

Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor.

Feedback: Consider the following example (Table):

Table from question 2, Chapter 12:

MRC = $18 Supply monopsony

competitive wage = $14 MRC=Supply competitive

monopsony wage = $12

MRC = $18 Supply monopsony

competitive wage = $14 MRC=Supply competitive

monopsony wage = $12

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