LECTURE NOTES FOR PRINCIPLES OF MACROECONOMICS

PROF. REGINA TREVINO

Lecture Six:
The Labor Market

We will now examine what determines the quantities of inputs (capital and labor) that

producers use. For now, we will assume a fixed capital stock.

In contrast, to the amount of capital, the amount of labor employed in an economy

can change fairly quickly, for example, firms may layoff workers or ask them to work

overtime without much notice. Thus year-to year changes in production often can be

traced to changes in employment. To explain why employment changes, we need to focus

on the labor market, that is, the demand and supply of labor.

6.1 THE DEMAND FOR LABOR

We will make the following assumptions regarding the labor market:

1. All workers are alike

2. Firms are price takers (they take wages as given)

3. Each firm’s goal is to maximize profits

To figure out how many workers to employ, the firm must compare the costs and

benefits of hiring each additional worker. The cost of an extra worker is the worker’s

wage, and the benefit of an extra worker is the value of the additional goods or services
the worker produces. As long as the benefit of additional labor exceeds the cost, hiring

more labor will increase the firm’s profits. The firm will continue to hire additional labor

until the benefit of an extra worker equals the cost.

More formally, in a competitive market, firms can sell as much output as they want

at the going market price p, and can hire as much labor, L, as they want at the going

market wage W (nominal wage). Facing W and p, a profit maximizing firm will hire L to

the point where

p  MPL = W (6.1)

The left-hand side of equation (6.1) is the benefit of hiring an additional worker (called

the marginal revenue product) and the right-hand side is the cost of hiring the worker in

nominal terms.

We can rewrite equation (6.1) to measure benefits and costs in real terms. The real

cost of adding a worker is the real wage, which we will denote by w , and is equal to:

W
w=
p

A profit-maximizing firm will hire workers to the point where the marginal product of

labor is equal to the real wage:

MPL = w

Recall that with Cobb-Douglas production function:

0.3
K
MPL = 0.7 A  .A firm that maximizes profits will hire workers until
L

0.3
K
0.7 A  = w.
L

If MPL  w , then the firm can increase profits by increasing L. If MPL  w , then the

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firm can increase profits by decreasing L.

Figure 6.1 shows in more general terms the determination of labor demand. The

optimal amount of labor demanded, L*, is determined by the intersection of the MPL and

the real wage rate (which the firm takes as given). The MPL curve slopes downward

because of diminishing marginal productivity of labor. The labor demand curve, LD, is

identical to the MPL curve.

w*
Real wage

MPL curve and labor

demand curve, LD

L* L

Labor Demand and MPL Curve. FIGURE 6.1

The aggregate demand for labor is the sum of labor demands of all the firms in the

economy. The factors that determine the aggregate demand are the same as those for an

individual firm and the curve looks the same as the labor demand curve for an individual

firm depicted in figure 6.1.

6.1.1 Factors that Shift the Labor Demand Curve

Changes in the real wage are represented as movements along the labor demand curve.

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The labor demand increases (i.e., shifts to right) in response a positive supply shock (an

increase in A) that increases the MPL.

An increase in K will also cause the labor demand curve to shift to the right. To see

why an increase in capital also increases the demand for labor we need to talk about the

complementarity across the inputs.

The MPL will depend on both the number of workers (i.e., the higher the number of

workers, the lower the marginal contribution of one extra worker) and also on the amount

of capital installed in the firm. How will K affect the productivity of workers? It turns

out that most kinds of capital are complementary to labor, especially when it comes to

qualified labor (even a robot which would seemingly replace human inputs will increase

the marginal value of an engineer that can manipulate it).

A widespread consequence of this complementarity is that when we compare

workers with similar qualifications across countries, wages are much higher for those in

more developed economies (i.e., economies with more capital). This phenomenon can be

seen in our model. Consider the U.S. market for labor. Provided capital and labor are

complements, as capital increases the marginal product of labor will increase for each

level of labor. This is represented by a shift to the right of the U.S. aggregate demand for

labor. Since capital increases the value of additional workers, firms want to hire more of

them. A higher demand for workers is then translated into higher real wages.1

6.2 THE SUPPLY FOR LABOR

Firms determine the demand for labor, but individuals or members of a family (making a

1
Note that higher real wages will provide strong incentives for workers to immigrate into high capital
countries.

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joint decision) determine the supply of labor. Each person of a working age must decide

how much to work (if at all) in the wage-paying sector of the economy vs. non-wage

paying alternatives (school, household activities, being retired). The aggregate supply of

labor is the sum of the labor supplied by everyone in the economy.

6.2.1 A Formal Model of Labor Supply

The individual makes her decision of how much to work by weighting the benefits and

costs of working. The main benefit of working is the income earned. The main cost is

that work involves time and effort that are no longer available for leisure (all off-the-job

activities including eating, sleeping, spending time with family and friends, etc.).

Suppose that consumers (or households) have a fixed amount of time in each period

which they can divide between work and leisure. The consumer can choose to work a lot

and have a relatively high consumption or can choose to work a little and have a small

consumption. The amount of consumption and labor will be determined by the interaction

of the consumer’s preferences and the budget constraint.

Consumer’s Preferences

We assume households only care about 2 aggregate goods: consumption, C, and leisure,

R (for relaxation). Households have a utility function U (C , R ) , which indicates the

amount of utility (or satisfaction) that the consumer receives when her consumption is C

and her leisure hours are R. If consumption or leisure increases, the utility increases.

As usual we can represent graphically this utility function with an indifference

curves map. Recall from lecture two we refer to the slope of an indifference curve at a

particular point as the marginal rate of substitution (MRS). The name comes from the

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fact that the MRS measures the rate at which the consumer is willing to substitute one

good (consumption) for another (leisure). Since the MRS is the numerical measure of the

slope of an indifference curve it will be a negative number.

Budget Constraint

Assume that the consumer starts with some real non-labor income M (for example, gifts

from parents) that she receives whether she works or not. Denote the price of

consumption by p, for convenience we will normalize the price of consumption to $1.

Let w denote the real wage rate (where w= W/p), L the amount of labor supplied by and C

the amount of consumption. The consumer’s budget constraint (expressed in real terms)

is given by:

C = M + w L (6.2)

Equation (6.2) says that what the consumer consumes must be equal to her non-labor

income plus her labor income.

Let T denote the maximum amount of labor supply possible (for example, 24 hrs.

per day), it must be the case that L + R = T .

If the consumer chooses to work L hours, then her corresponding leisure is

R = T − L and can rewrite equation (6.2) as follows:

C + w R = M + wT (6.3)

Equation (6.3) says that the value of a consumer’s consumption plus her leisure (left-hand

side of 8.3) has to equal the value of her endowment of consumption and her endowment

of time (called full income). This means that the real wage rate is not only the price of

labor; it is also the price of leisure. If, for example, your wage rate is $10 an hour and

you decide to consume and extra hour of leisure, how much does it cost you? It costs you

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$10 in forgone income. That is why economists say that the wage rate is the opportunity

cost of leisure.

Optimality

The consumer faces the following maximization problem:

max U(C, R)
C ,R

subject to: C + w  R = M + w  T

The optimal choice occurs (R*, C*) where the marginal rate of substitution between

leisure and consumption, MRS , equals the real wage w, that is:2

MRS = w (6.4)

The optimality condition in (6.4) implies the usual tangency between the budget

constraint and the consumer’s indifference curve. Figure 6.2 depicts this optimal choice.

Consumption Indifference curve

M+wT

Optimal choice

C*

Budget constraint
slope=-w

R* T Leisure

Optimal Labor Supply Choice. FIGURE 6.2

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We will not go through the calculus solution of this problem. We will mainly focus on the graphical
analysis. For those of you that are curious about the optimality condition it simply follows from the first
order conditions of the maximization problem.