EAE 304 - Labour Economics-1

UNIT CODE: ECO 322
UNIT NAME: LABOUR ECONOMICS
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Table of Content
INTRODUCTION…………………………………..…………………………………………….3
LESSON ONE: Introduction…………………………………….………………………………..5
The actors in the labour market……………………………………………..…………………….6
LESSON TWO: Labour Supply……………………………………………………..…………..11
Introduction…………………………………………………………………………………...…11
Measuring Labour Force………………………………………………………………………...11
The Workers Preferences……………………………………………………………….……….23
The Labour Supply Curve for a Worker………………………………………………………..24
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Policy Application………………………………………………………………………….…..25
LESSON THREE: LABOUR DEMAND…………………………………………………….27
Introduction……………………………………………………………………………………27
Production Function……………………………………………………………………….…..28
Long-run Demand
Curve…………………………………………………………………………………………..34
LESSON FOUR: LABOUR MARKET EQUILIBRIUM:WAGE AND EMPLOYMENT
DETERMINATION……………………………………………………………….…………40
Monopsony Market……………………………………………………………………………44
Monopoly Market………………………………………………………………………..……45
Bilateral Monopoly Market………………………………………………………………..….46
Minimum wage Model………………………………………………………………………..54
LESSON FIVE: WAGE THEORIES………………………………………………………….58
Subsistence Theory…………………………………………………………………………….59
Wage Fund………………………………………………………………………………….…60
Residual Claimant………………………………………………………………………………61
Marginal productivity………………………………………………………………….………64
Modern Theory………………………………………………………………………………...65
LESSON SIX: HUMAN RESOURCE DEVELOPMENT…………………………….……67
Introduction……………………………………………………………………………..……67
The Schooling Model…………………………………………………………………………68
LESSON SEVEN: OCCUPATIONAL WAGE DIFFERENTIALS……………………….69
Introduction…………………………………………………………………………………….69
The Risk………………………………………………………………………………………..70
LESSON EIGHT: LABOUR MARKET DISCRIMINATION……………………………...74
Introduction…………………………………………………………………………………...74
The Neoclassical Taste Model…………………………………………………………………75
Labour Market Segmentation Approach…………………………………………………..…….80
Dual Labour Market Hypothesis……………………………………………………………….81
LESSON NINE: LABOUR UNIONS………………………………………………..……85
Introduction……………………………………………………………………………….…85
Wages and Benefits…………………………………………………………………………86
Industrial Relations……………………………………………………………………….…87
Economic Impacts of Unions………………………………………………………………..89
Union and Inflation……………………………………………………………………….…94
Union and Wages…………………………………………………………………………….95
LESSON TEN: UNEMPLOYMENT AND UNDEREMPLOYMENT……………………98
Introduction…………………………………………………………………………………98
Types of Unemployment……………………………………………………………………99
Non-Sequential and Sequential Search……………………………………………………..100
The Asking Wage…………………………………………………………………………..102
LESSON ELEVEN: LABOUR MOBILITY……………………………………………….103
Introduction………………………………………………………………………………….103
Types of Mobility of Labour………………………………………………………………..106
Obstacles of Mobility of Labour…………………………………………………………….107
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Determinants of Workers Mobility…………………………………………………………..108
INTRODUCTION
The study of labour economics embraces many areas of interest. They may be grouped into three
broad categories. These are labour market analysis, labour market problems and policies and
union and management: collective bargaining.
Employers and workers buy and sell labour services in a labour market. Because the services are
usually difficulty to quantify, they are typically measured either by number of workers or by
hours of labour time. You can gain understanding of the labour market by examining these
fundamentals features:
- Supply of and demand for labour
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- Wage determination and employment
- Labour-market imperfections
OBJECTIVE
The goal of this course is to enhance the capacity of learners to understand theories, concepts,
policies and their application in analyzing labour markets issues, undertake impact evaluation of
labour market programs and policies, and to contribute to evidenced-based policy discourse.
Lesson one
Introduction
Introduction
Most of us will allocate a substantial fraction of our time to the labour market. What we do in
the labour market helps determine our wealth, the types of goods we can afford to consume,
whom we associate with, where we vacation, which schools our children attend, and even the
type of persons who find us attractive. As a result, we are all eager to learn how the labour
market works. Labour economics studies how labour markets work.
Objectives
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By the end of the lesson the learner should be able to:
1. Define the term labour economics
2. Explain the role of each actor in the labour market
The interest in labour markets arise not only from our personal involvement, however but also
because many social policy issues concern the labour market experiences of particular groups of
workers or various aspects of the employment relationship between workers and firms. The
policy issues examined by modern labour economics include:
1) What is the impact of immigration on the wage and employment appointments of native –
born workers?
2) Do minimum wages increase unemployment rate of less skilled workers?
3) What is the impact of occupational safety and health regulators on employment and
earnings?
4) Are government subsidies of investments in human capital an effective way to improve an
economic well-being of disadvantaged workers?
5) What is the impact of the affirmative action program on the earnings of woman and
minorities and on the number of woman and minorities that firms hire?
6) What is the impact of unions both on their members and on the rest of the economy?
7) Do generous unemployment insurance benefits lengthen the duration of spells of
unemployment?
8) Why is the unemployment rate much higher in less developed economies than in developed
economies?
The above list of social issues clearly illustrate why the study of labour markets is very
important and very interesting. Labour economics helps us understand and address many of the
social and economic problems facing the modern societies.
An Economic Story of the labour Market
Labour economists assign motives to the various actors in the labour market e.g we view
workers for trying to find the best possible job and assume that firms are trying to make money.
Workers and firms therefore enter the labour market with different objectives. Workers are
trying to sell their labour at the highest price and firms are trying to buy labour at the lowest
price.
The types of economic exchange that can occur between workers and firms are limited by the set
of ground rules that the government has enacted to regulate transactions in the labour market.
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Changes in these rules and regulations would obviously lead to different outcomes. E.g a
minimum wage law prohibits exchange that pays less than a particular amount per hour worked;
occupational safety regulations forbid firms from offering working conditions that are deemed
too risky to the workers’ health.
The study of labour economics helps understand and predict how some labour market outcomes
are more likely to observe than others. We need fact and theory of why workers and firms
pursue some employment relationships and avoid others.
We predict the impact on the labour market of changes in the government policies or changes in
the demographic composition of the labour force.
We need to understand which economic and social factor generate a certain level of employment
and why.
The actors in the labour market
There are three actors in the labour market: workers, firms and government. Workers decides
whether to work or not, how many hours to work, which skills to acquire, when to quit a job,
which occupation to enter, whether to join a labour union and how much effort to allocate to the
job. Each of these decisions is motivated by the desires to optimize, to choose the best available
option from the various choices. Therefore workers will always act in ways that maximize their
well-being. Adding up the decisions of millions of workers generates the economy’s labour
supply, not only in terms of the quantity but also quality of skills available to the employers. As
we will see many times, persons who want to maximize their well-being tend to supply more
time and more effort to those activities that have a higher payoff. The labour supply curve
therefore is upward sloping.
Firm is the second actor each firm must decide how many and which types of workers to hire
and fire, the length of the workweek, how much capital to employ, and whether to offer a safe or
risky working environment to its workers. The firm will always aim at maximizing profits. The
firm will maximize its profits by making the production decisions- and hence the hiring and
firing decisions- that best serve the consumer’s needs. In effect, the firms demand for labour is a
derived demand, a demand derived from the desires of consumers.
The government is the third actor in the labour market. It can impose taxes on a worker’s
earnings, subsidize the training of a particular category of workers, and increase the supply of a
particular category of workers by encouraging their immigration from abroad and design
policies and regulations that govern the operations of the labour markets. All the above will
change the equilibrium that will eventually be attained in the labour market. Government
regulations, therefore set the ground rules that guide exchange in the labour market.
An overview of Labour Economics
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Micro economics focuses on the determinant of labour supply and demand and the way supply
and demand interact to determine the wage rates and employment in various labour markets. In
these labour markets, the type and composition of pay are determined by, the wage structure.
Some wage differential persists; others are eroded by mobility and migration. Labour unions,
government and discriminations all affect labour markets through either supply or demand.
Macroeconomic stresses the aggregative aspect of labour markets and in particular distribution
of earnings, labour production and the overall level of employment.
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Supply of
Labour
Figure 1.0 Efficiency pay Wage structure Mobility and
schemes migration
Work leisure
decision
Unions and Collective

Micro-Economic Bargaining’s
aspect of Labour
Participation Labour
rates markets
Government
Quantity of
Labour labour
Economic Discrimination
Job search
Demand of
labour
Distribution of
personal earnings
Macro-Economic Production
aspect of Labour
Employment and
unemployment
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Micro economic is concerned with the decisions of individual economic units and the
functioning of specific markets.
Macro-economic is concerned with the economic as a whole or with basic aggregates

that constitutes the economy.
Summary
 Labour economic studies how a labour markets work

 The three actors in the labour economics are the individuals, firms and the
policy institutions such as the government and trade unions.
Activity
State the policies examined by the modern labour economics
Further Reading
Addison, J.T and W.S. Siebert (1979). THE MARKET FOR LABOUR. AN
ANALYTICAL TREATMENT. SANTA MONICA, CALIFORNIA: GOODYEAR
PUBLISHING COMPANY,INC
Smith,S.W (1994). Labour Economics, Routledge:London
McConnell, C.R and S.L. Brue (1995). Contemporary Labour Economics, Fourth
Edition. Singapore : McGraw-Hill Inc.
Bosworth, D. Dawkins and T. Stromback (1996). The Economics of the Labour
Market, England and Singapore: Addison Wesley Longman Limited.
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Lesson Two
Labour Supply
Introduction
This chapter develops the framework that economists use to study labour supply
decisions. In this framework, individuals seek to maximize their wellbeing by
consuming goods and leisure. Goods have to be purchased in the market place,
The model of labour-leisure choices isolates the persons wage rate and income as the
key economic variables that guide the allocation of time between the labour market
and leisure activity. In this chapter, we use the framework to analyze static labour
supply decisions, the decisions that affect a person’s labour supply at a point in time.
The market for labour, like the market for any commodity, is affected by supply and
demand forces. But there are a number of different concepts of labour supply and of
labour demand that must be identified before you can understand the labour market.
Objectives

1. Define labour supply
2. Determine hour allocated to work and leisure
3. Derive labour supply curve
Before analyzing the factors that determine wages, it helps to begin with some
definitions.
Measuring the Labour Force
1 Labor, as defined in economics, means all personal services, including the

activities of wage, workers, professional people, and independent businesspeople.
Thus, "laborers" are workers of any sort, whether they receive compensation in the
form of hourly wages or in the form of annual salaries, bonuses, or commissions. Our
interest in this chapter is in wages as defined above, especially in wages expressed as
time rates.
2 Labor Force This concept of labor supply is simply the employable

population. It is defined for measurement purposes as all people 16 years of age or
older who are employed plus all those who are unemployed but actively seeking
work. Let E be the number of persons considered to be employed, and U the number
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of persons considered to be unemployed. A person participates in the labour force if
he or she is either employed or unemployed. The size of the labour force (LF) is
given by:
LF = E + U
3 Labor-force Participation Rate This is the percentage of the total population

(P), or of one or more subgroups of the population, that is in the labor force.
Subgroups are classified by race, sex, age, marital status, and other demographic
characteristics. Thus, the percentage of the nation's white population that is in the
labor force would be one type of labor force participation rate. The percentage of the
nation's white males that is in the labor force would be another. The percentage of the
nation's white males, ages 19 to 24, that is in the labor force would be still another.
And so on. Some illustrations of labor force participation rates are shown in Exhibit 1.
Labour force participation rate = LF/P
Labor-Force Participation by Women
The participation rate of married women in the labor force has increased
substantially in recent decades. Some major reasons are:
Improved Marketability Changing social and cultural attitudes toward women

have enabled them to advance their education and skills. This has made their talents
more salable in the market. More Service Occupations The economy is becoming
less based on factories and more on services. This creates greater varieties of jobs
for which women can compete.
Declining Family Size The average size of the family has declined since the 1960s.
This has freed women to work outside the home.
4 Employment-population ratio, sometimes called the employment rate, gives

the fraction of the population that is employed, or:
Employment – population ratio = E/P
5 Unemployment rate gives the fraction of labour force participants who are
unemployed:
Unemployment rate = U/LF
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The Worker’s Preferences
The framework that economists typically use to analyze labour supply is called the
neoclassical model of labour – leisure choice. The model isolates the factors that
determine whether a particular person work and if so, how many hours she chooses to
work.
The representative person in our model receives satisfaction from consuming goods
(C) and from consumption of leisure (L).
Utility and indifference curves

The fact that individuals to get satisfaction from consuming goods and leisure is
summarized by the utility function: U = f (C, L).
Figure 2.0
Consumption
Y
500
Z
450
X 40,000 utils
400
25,000 utils
Hours of leisure
13
Points x and y lie on the same indifference curve and yield the same level of utility.
Point z lies on higher I.C and yields more utility.
Indifference curves have four important properties:
 I.C are downward sloping
 Higher I.C indicate higher level of utility
 I.C do not intersect
 I.C are convex to the origin
The slope of an I.C
The slope of I.C measures the rate at which a person is willing to give up leisure time
in return for additional consumption while holding utility constant
C MUL

L MUc
The Budget Constraint
The person’s consumption of goods and leisure are constrained by his time and by her
income. Part of the person’s income such as property income, dividends and lottery
prices is independent of how many hours she works. This is non labour income (v).
Let (h) be the number of hours the person will allocate to the labour market during the
period, and (w) be the hourly wage rate. The person’s budget constraint can be written
as:
C = Wh + V
That is the expenditure on goods (C) must be equal to the sum of labour earnings
(Wh) and non labour income (V)
A person has two alternative uses for her time; work or leisure. The total time
allocated to each of these activities must be equal to the total time available in the
period T, per week. So that
T=h+L
Budget constraint can be written as:
C = W (T-L) + V or
C = (WT + V) – WL
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Figure 2.1
WT + V
Budget line
V E
Hours of leisure
Point E indicates that if the person decides not to work at all and devotes T hours to
leisure activities she can still purchase V worth of consumption goods. Point E is the
endowment point. If the person is willing to give up one hour of leisure, she can then
move up the budget line and purchase an additional W worth of goods. The worker
moves up the budget line as she trades off an hour of leisure for additional
consumption. The slope of the budget line is wage rate.
The Hours-of-Work Decision

The person wishes to choose the particular combination of goods and leisure that
maximizes her utility. This means that the person will choose the level of goods
consumption and leisure activities that lead to the highest possible level of the utility
(U), given budget constraint.
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Figure 2.2
An interior solution to the labour –

F leisure decision
X
y
p
500
U1
U0
E U2
Hours of leisure
70 110
110 40 0 Hours of work
Point P gives the optimal bundle of consumption goods and hours of leisure chosen by
the utility-maximizing worker. At point P IC is tangency of the budget line. At this
solution worker consumes 70 hours of leisure per week and work 40 hrs and
consumes 500 worth of goods weekly.
At tangency point P slope of the I.C is equal to the slope of the budget line.
MUC = W
MUL
What happens to hours of work when non labour income changes?
The increase in V might be triggered by the payment of higher dividends on the

workers stock of portfolio or perhaps because some distant relatives had named the
workers as the beneficiary in their will.
Figure 2.3
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F1
F0 P1
P0 U1
U0 E1
E0
70 80 Hours of leisure
The increase in non labour weekly shifts the endowment point to E, so that the new
budget line is given by F1 E1. Because the workers wage rate is being held constant,
the slope of the budget line originating at point F1 is the same as the slope of the
budget line at point E0
The worker will move from point P0 to P1. If leisure is a normal good hours of work
fall. If leisure is an inferior good hours of work increase.
P1
U1
P0
E1
U0
E0
Figure 2.4
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60 70 Hours of leisure
The impact of the change in non labour income (holding wage constant) on the
numbers of hours worked is called an income effect
What happens to hours of work when the wage changes?

Consider a wage increase from $10 to $20 holding non labour income V constant. The
wage increase rotates the budget line around the endowment point.
Figure 2.5
(a)
G
R
F
P U1
(b)
Slope = -20
U0
R Slope = -10
U E
U1
70 75
P U0
Figure 2.6
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65 70
Fig 2.5. The wage increase shifts the optimal consumption budget from point P to
point R. At the new equilibrium; the individual consumes more leisure from 70 to 75
so that hours of work fall from 40 to 35 hours.
Fig 2.6. The wage increase moves the worker to a higher indifferent curve and shifts
the optimal consumption bundle from P to R. The wage increase reduces the leisure
hours.
It seems therefore that, we cannot make an unambiguous prediction about wage

increase without making more assumptions.
The reason for the ambiguity in the relationship between hours of work and the wage
rate is of fundamental importance and introduces a set of tools and ideas that play
central role in economics.
Regardless of what happens to hours of work, wage increase expands the workers
opportunity set. In other words, a worker has more opportunities when she makes $20
an hour than when he makes $10 an hour. An increase in income increases the
demand for all normal goods, including leisure. The increase in the wage thus
increases the demand for leisure, which reduces hours of work. But this is not all that
happens. The wage increase also makes leisure more expensive. When worker earns
$20 an hour, he gives up $20 every time he devotes an hour to leisure activities. As a
result, leisure time is very expensive commodity for high-wage workers and relatively
cheap commodity for low-wage workers.
High wage workers should then have strong incentives to cut back on their
consumption of leisure activities. A wage increase thus reduces the demand for leisure
and increases hours of work.
A high wage worker wants to enjoy the rewards of his high income and hence would
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like to consume more leisure. The same workers, however finds that leisure is very
expensive and that she simply cannot afford to take time off from work. These two
conflicting forces are illustrated below.
Figure 2.7
(a) Decomposition of the impact of a wage

change into income and substitution effect
R
U1
Q
F
U0
D
70 75 85 110
Figure 2.8
(b)
Q U1
F
P
U0
Fig 2.7 60 70 85
20
The workers maximizes his utility choosing the consumption bundle given by point P.
Suppose the wage increases to $20, the new consumption bundle is given by R. The
person is working at fewer hours at the higher wage. Movement from P to R is a two-
stage move. That is, the wage increase generates two effects: it increases the workers
income and it raises the price of leisure. To isolate the income effect, suppose we
draw a budget line that is parallel to the old budget (so that its slope is also $10) but
tangent to the new I.C. this budget line ΔD generates a new tangent point Q.
The move from initial position P to final position R can then be decomposed into
first-stage move from P to Q and a second-stage move from Q to R. It is easy to see
that the move from P to Q is an income effect. In particular, the move from P to Q
arises from a change in the worker’s income, holding wages constant. The Income
effect isolates the change in consumption bundle induced by the additional income
generated by the wage increase. Because both leisure and goods are normal goods;
point Q must lie to the north east of point P (so that more is consumed of both goods
and leisure). The effect thus increases the demand for leisure (form 70 to 85hrs) and
reduces hours of work by 15hrs.
The second-stage move from Q to R is called the substitution effect. It illustrates what
happens to the workers consumption bundled as the wages increases holding utility
constant. By moving along an Indifference curve the worker,s utility is held fixed.
The substitution effect thus isolates the impact of the increase in the price of the
leisure on hours of work holding income constant.
The move from Q to R generates a substitution away from leisure time and towards
consumption of other goods. In other words, as the wage rises, the workers devote
less time to expensive leisure activities (from 85 to 75 hrs) and increase in
consumption of goods. Through the substitution effect, therefore, the wage increase
reduces the demand for leisure and increases hours of work by 10 hrs. The
substitution effect implies that, an increase in the wage rate, holding income constant,
and increases hours of work.
The decrease in hours of work generated by the income effect (15 hrs) exceeds the
increase in hours of work associated with the substitution effect (10 hrs). The stronger
income effect thus leads to a negative relationship between hours of work and the
wage rate.
Fig 2.8.
The income effect (P Q) decreases hours of work by 10hrs, whereas the
substitution effect
(Q R) increases hours of work by 15 hrs. Because the substitution effect
dominates, there is a positive relationship between hours of work and the wage rate.
The reason for the ambiguity in the relationship between hours of work and the wage
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is now clear. As the wage rises, a worker faces a larger opportunity set and the income
effect increases his demand for leisure and decreases labour supply. As the wage
rises, however wage becomes more expensive, and the substitution effect generates
incentives for that worker to switch from consumption of leisure to other types of
consumption activities. This shift frees up leisure hours and thus increases hours of
work.
To summarize the relation between hours of work and the wage rate
 An increase in the wage rate increases hours of work if the substitution effect
dominates the income effect.
 An increase in the wage rate decreases hours of work if the income effect
dominates the substitution effect.
To work or not work?
Our analysis of the relation between non-labour income, the wage rate, and the hours
of work assumed that the person worked both before and after the change in non-
labour income or the wage. Hours of work then adjusted to the change in the
opportunity set. But what factors motivate a person to enter the labour force in the
first place.
Figure 2.9
W High
G X
W Low uh
E
U0
UG W
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The person who does not work at all receives no utility. The person, however, can
choose to enter the labour market and sell off some of her leisure time. The decision
of whether to enter the labour market or not boils down to a simple question: Are the
terms of trade – the rate at which leisure can be traded for additional consumption –
sufficiently attractive to bribe him into entering the labour market?
Suppose initially that the person wage rate is given by Wlow so that he faces budget
line GE. No point on this budget line can give him more utility than μ 0. At this low
wage, the persons apportunities are quite meager. If the worker were to move from the
endowment point E to any point on the budget line GE, he would be moving to a
lower Ind. curve and be worse off; e.g at point X he gets only μg. At wage W low, the
person chooses not to work. In contrast, suppose that the wage rate was given by W
high, so that the worker faces budget line HE. It is easy to see that there are many
points on this steeper budget line that would increase the workers utility. At point Y,
the worker gets μH. At the wage Whigh he is better off working.
The diagram indicates that the worker does not enter the labour market at low wage
rates (such as W low) but does enter the labour market at high wage rates (such as
Whigh). As we rotate the budget line from Wlow to wage (W high), we will
encounter a wage rate (W) that makes him indifferent between working and not
working. (W) is known as the reservation wage. Reservation wage gives the minimum
increase in income that would make person indifference between remaining at
endowment at point E and working that first hour. Reservation wage is given by the
slope of the Ind. curve at point E
This implies that the person will not work at all if the market wage is less than the
reservation wage, and the person will enter the labour market if the market wage
exceeds the reservation wage. The decision to work therefore is based on comparison
of the market wage, which indicates how much the employers are willing to pay for
an hour, and the reservation wage, which indicates how much the worker requires to
be bribed into working that first hour.
The theory implies that a high reservation wage makes it less likely that a person will
work. The reservation will depends on the person’s taste for work, which helps to
determine the slope of the Ind. curve as well as many other factors. E.g the
assumption that leisure is a normal good implies that the reservation wage rises as non
labour income increases. In other words, a higher wage of non labour income
increases the reservation wage making it less likely that a person will participate in
the labour force. Because workers want to consume more leisure as non labour
income increases, a larger bribe will be required to convince a higher-income person
to enter the labour market.
Holding the reservation wage constant, the theory also implies that higher-wage
23
persons are more likely to work. A rise in the wage rate increases the labour force
participation rate of a group of workers. There is a positive relationship between wage
rates and probability of working.
The Labour Supply Curve for a Worker
The relation between hours of work and the wage rate is called the labour supply
curve. It traces out the relationship between the wage rate and hours of work.
Figure 2.10
W=25
W=20
W=13 U
E W=10
70 80 90 110
Figure 2.11
25
Labour supply curve
20
13
10
At the wages below the

20reservation
30 wage ($10)
40 the person does not work. At higher
24
wages than $10 the person enters the market. The upward sloping segment of the
labour supply curve implies that substitution effects are stronger initially; the
backward bending segment implies that income effects may dominates eventually.
At reservation wage the person supplies zero hours to the labour market at any wage
less than or equal to $10. Once the wage rises above $10, the person chooses to work
some hours, e.g he works 20 hrs when wage = $13, 40hrs when wage is 20 and 30
hour when the wage is $25.
Policy application: welfare programs and work incentives

Cash grants and labour supply.
Consider a simple program that grants eligible person’s cash grant e.g unmarried
woman or unemployed youth are given a cash grant of $500 per month as long as they
remain outside the labour force. If these person’s enter the labour market, the
government officials immediately assume that the person no longer need public
assistance and are dropped from the welfare.
The impact of the cash grant on work incentive is illustrated below.

Figure 2.12
P G
500
U1
U0
70 110 Hrs of leisure
25
In the absence of the program, the budget line is given by FE and leads to an interior
solution at point P, in which the person consumes 70hrs of leisure and works 40hrs.
Assume that a person does not have any non labour income. The introduction of a
cash grant of $500 non workers then introduces point G into the opportunity set. At
this point, a woman can purchase $500 worth of consumption goods if she participates
in the welfare program and does not work. Once the person enters the labour market,
however the welfare grant is taken away and the opportunity set switches back to the
original budget line FE.
The existence of the cash grant at point G can greatly reduce the work incentives. The
person attains a higher level of utility by choosing a corner solution by point G (that is
the welfare solution) than by choosing the interior solution at point P (work solution).
This type of take-it or leave it cash grant can induce many workers to drop out of the
labour force. It should be clear that low-wage persons are most likely to choose the
welfare solution. Improvement in the endowment point ( from point. E to point G)
increases the workers’ reservation wage, thus reducing the likelihood that a low-wage
person will enter the labour market.
SUMMARY
 The reservation wage is the wage that makes a persion indeffent between
working and not working. A person enters the labour market when the market
wage rate exceeds the reservation wage.
 Utility – maximization workers allocate their time so that the last$ spent on
leisure activity yields the same utility as the last $ spent on goods.
 An increase in nonlabour income reduces hours of work of worker.
 The participation rate of married women in the labor force has increased
substantially in recent decades.
 The supply curve of labor to a particular occupation is more elastic in the long
run than in the short run because people have time to train for new
occupations
 The existence of a backward-bending labor supply curve tells you that people
allocate their limited time between work and leisure (i.e., non-work).
Activity
26
1 We can demonstrate that a welfare program that includes a cash grant and a
tax on labour earnings must reduce labour supply.
2 What happens to the reservation wage if nonlabour income increases and
why?
3 What economic factors determine whether a person participate in the labour
force?
Further Reading
Smith,S>W (1994). Labour Economics, Routledge:London
Hardwick, P. B. Khan and J. Langmead (19996). An introduction to Modern
Economics, Fourth Edition. Edinburge and Singapore: Addison Wesley Lomgman
Limited.
George J. BorjasLabour Economics. Third Edition McGraw-Hill R
Irwin.
Lesson Three
27
Labour demand
Introduction
Labour market outcomes, depends not only on the willingness of workers to supply
their time to work activities, but also on the willingness of firms to hire those workers.
We now turn, therefore to a discussion of the demand side of the labour market. Our
analysis of labour demand begins by recognizing that firms do not hire workers
simply because employers want to see “bodies” filling in various positions in the firm.
Rather, firms hire workers because consumers want to purchase a variety of goods
and services. The firm’s labour demand-just like the firm’s demand for other inputs in
the production process , such as land, buildings and machines-is a derived demand
from the wants and desires of consumers.
Objectives
Objectives
1. Define demand for labour
2. Derive demand curve for labour
3. Isolate substitution and income effect of a wage change
The Production function
It describes the technology that the firm uses to produce goods and services. Assume
that there are two factors of production (two inputs in the production process). i.e
number of employees hours hired by the firm (L) and capital (K)
Q = F (L,K). Q = firms output. The production function specifies how much output
is produced by any combination of labour and capital. The definition of the labour
input makes two assumptions that are very restrictive and that are worth noting. The
number of employee-hours L is given by the product of the number of workers hired
times the average number of hours worked per person. The production function also
28
assumes that different types of workers can somehow be aggaregated into a single
input that we call labour.
Marginal Product and Average Product
The most important concept associated with the production function is that of
marginal product. The Marginal product of labour (MPE) is defined as the change in
output resulting from having an additional worker, holding constant the quantities of
all other inputs. Similarly, the marginal product of capital (MPk) is defined as the
change in output resulting from a one unit increase in the capital stock, holding
constant the quantities of all other inputs. We assume that the marginal products of
both labour and capital are positive numbers, so that hiring either more workers or
capital leads to more output.
We can also define average product of labour (Ape) as the amount of output produced
by a typical worker.
Ape = q/E
Figure 3.0: Graphs of Production Function

Total
Output C
(Q) 120
TPL
Panel a
Total Production
function
A
6 ΔQ
8
36 ΔL
v
0 3 4 8 Units
of labor
MP, AP (L)
d
32
Panel b
19 e
Average and
Marginal
APL
Product
function
f
0 1 4 6 8 MPL Units of Labor (L)
29
Total product curve gives the relationship between output and the number of workers
hired in the firm holding capital fixed. The marginal product curve gives the output
produced by each additional worker and the average product curve gives the output
per worker.
Profit maximization
To analyze the hiring decisions made by the firm, we make an assumption about the
firm’s behaviour. The firm’s objective is to maximize it’s profit given by:
π = PQ – WE - rK.
When P = price of output
W = wage rate
r = price of capital
We also assume that the firm is a perfectly competitive; thus the firm cannot influence
prices.
The employment decision in the short-run

Define the short run as the time span that is sufficiently brief that the firm cannot
increase or reduce the size of tis plant or purchase or sell physical equipment. In the
short run, therefore, the firm’s capital is fixed at some level.
To obtain the value of what each additional worker produces, we multiply the MPE X
prices of the output. This quantity is called the value of the MPE
VMPE = P x MPE
Also
VAPE = P x APE
How Many Workers Should the Firm Hire ?
The
W competitive firm can hire all the labour it wants at constant wage of W dollas. A
profit maximizing firms has workers up to the point where the wage rate equals the
value of marginal product of labour. VMPE = W
Figure 3.1
38
V
APE
22
W
V P
M E
30
1 4 8
Suppose the wage in the labour market is $22 then the firm should hire 8 workers. At
this level of employment, the VMPE = W and VMPE is declining. The intuition for
this result is that suppose the firm decides to hire only six workers e.g 7 worker,
would get more additional revenues than it would pay out to that worker (26$ and 22$
). A profit maximizing firm will want to expand and hire more labour. If the firm were
to hire more than eight workers, the VMPE would be lower than the cost of the line.
From a profit maximizing point of view, it is not worth having more than eight
workers.
NB. The wage would equal the VMPE if the firm hired just one worker. At that point,
however, the VMPE is upward sloping; hiring just one worker does not maximize
profits. If the firm hired another worker, the 2 nd worker hired would contribute even
more to the firm’s revenue than the first worker.
This argument shows why the law of diminishing returns plays such an important role
in our theory if VMPE kept rising the firm would maximize profits by expanding
indefinitely.
If the competitive wage were very high such as $38, the firm would hire 4 workers
where VMPE = W. However the VAP E (32) would less than the wage. Because the
per-worker contribution to the firm is less than the wage, the firm loses more and
leaves the market. The only points on the VMPE curve that are relevant for the firm’s
hiring decision are the once that lie on the download-sloping portion of the curve
below the point where the VAPE intersects the VMPE curve.
The short-run labour demands curve for a firm.
The demand curve tells us what happens to the firm’s employment as the wage
31
changes holding capital constant.
Figure 3.2
Wage
22
18
VMPE’’
’’’
VMPE
8 9 12 Number of Workers
VMPE = is the downward sloping pattern of the firms VMPE curve. The short-run
demand curve for labour therefore is given by the VMP E. Since it declines as more
workers are hired, it must be the case that fall in the wage increases the number of
workers hired.
The position of the labour demand curve depends on the curve of the output. Since
VMPE = P. MPE the short-run demand curve shifts up if the output becomes more
expensive e.g suppose that output price increases, shifting the VMPE curve from
VMPE to VMP’E. Thus there is a positive relation between short-run employment
and output price.
Employment Decision in the Long-Run
In the long-run, the firm’s capital stock is not fixed. The firm can expand or shrink it’s
plant size and equipment. Therefore in the L – R, the firm maximizes profit by
choosing both how many worker’s to be hired and how much plant and equipment to
invest in.
Isoqunt
It describes the possible combinations of labour and capital that produce the same
level of output Q = f(E, K)
Figure 3.3
q1 32
q0
Characteristics
− Downward sloping
− Do not intersect
− Higher iso-quant are associated with higher levels of output
− They are convex to the origin
Slope of iso-quant : δk = MPE

δE = MPK
Isocosts
The firm’s cost of production C is given by C = WE + rK
If firm decide to hire only capital then it could hire Co/r units of capital or if it could
hire only labour, then it hires Co/w workers.
Combinations of labour and capital that the firm could hire with a cost outlay of Co
are called an isocost line.
Figure 3.4
C1/r
Higher isocost lines imply higher costs
C0/r
C0/w C1/w
Cost minimization
A profit maximizing firm that is producing q0 units of output wants to produce these
units at the lowest possible cost.
33
Figure 3.5
C
A
175 P
B q0
100 E
The firm chooses the combination of labour and capital (100 workers and 175
machines) given by point P, where isocost is the target to the isoquant. The firm can
produce q0 unit of output using other capital-labour combinations such as point A or
B on the isoquant. This choice however could be more costly because it places the
firm on a higher isocost line.
At the cost-minimization solution P, the slope of the isocost equals the slope of the
isoquant.
MPE = W
MPK R
Long-Run demand curve for labour
What happens to the firm’s long-run demand for labour when the wage changes.
Consider a firm that produces q0 units of output. Assume that this output is the profit-
maximizing level of output in the sense that at that level of production output price is
equal to MC. A profit-maximizing firm will produce this output at the lowest cost
possible, so it uses a mix of labour and capital where the ratio of marginal products
equals the ratio of input prices. The wage is initially equal to w0. The optimal
combination of inputs for this firm is given below.
Figure 3.6
34
Co/r
R
P
75
W = W1
W = W0
employment 25 40
Suppose the market wage falls to W1, how will the firm respond? The firm would
move from point P to point R. The wage reduction increases the firm employment
from 25 to 40 workers and increases output to q1 units. The decline in the wage will
typically cut the marginal cost of producing the firm’s output. We then expect that the
drop in the wage would encourage the firm to expand production.
Figure 3.7
Mc0
Mc1
100 200 Output
Because the MC Curve drops from MCO to MC1, the wage cut encourage the firms to
35
produce 200 units of output rather than 100 units.
Therefore the firm will jump to a higher isoquant as shown below.

Figure 3.8
R
P
200
100
25 50 Employment
The total cost of producing 200 units of output need not to be same as the cost of
producing only 100 units. As a result the new isocost line need not originate from
the same point in the vertical axis as the old isocost line.
The employment will increase from 25 to 50, workers. The firm will always hire more
workers when the wage falls. The positioning of R also implies that the firm will use
more capital. This need not always be the case. In general, a wage cut can either
increase or decrease the amount of capital demanded.
Figure 3.9
Long-run demand curve
W0
W1
DLR
25 50
Substitution and scale effect
36
The wage cut reduces the price of labour relative to that of capital. The decline in the
wage encourages the firm to readjust its input mix so that it is more labour intensive.
In addition, the wage cut reduces the MC of production and encourages the firm to
expand. As the firm expands, it want to hire more workers.
Figure 3.10
C1/r
C0/r Q
R
P D 200
100
25 40 50 Employment
The firm is initially at point P, where it faces a wage equal to W O, produces 100 units
of output and hires 25 workers. When the wage falls to W 1, the firm moves to point R,
producing 200 units of output and hiring 50 workers.
The move from P to R is of two stages. In the first stage, the firm takes advantage of
the lower price of labour by expanding production. In the second stage, the firm takes
advantage of the wage change by rearranging its mix of inputs (i.e. by switching from
capital to labour), while holding output constant.
To conduct this decomposition, we introduce a new isocost line DD. DD is tangent to

the new isoquant (q = 200), but parallel to the isocost that the firm faced before the
wage reduction. The tangency point is given by Q.
The move from P to Q is the scale effect. Scale effect indicates what happens to the
demand for the firm’s inputs as the firm expands production. As long as capital and
labour are normal inputs the scale effect increases both the firm’s employment (from
25 to 40 workers) and capital stock.
In addition to expanding its scale, the wage cut encourages the firm to adopt a
different method of production, one that is more labour intensive to take advantage of
the now-cheaper labour. The substitution effect indicates what happens to the firm’s
employment as the wage changes, holding output constant and is given by the move
from Q to R. Holding output constant at 200 units, the firm adopt a more labour-
37
intensive input mix substituting away from capital and toward labour. Substituting
effect raises the firm’s employment from 40 to 50 workers. NB: The substitution
effect must decrease the firm’s demand for capital.
Both the substitution and scale effect induce the firm to hire more workers as wage
falls.
The above diagram indicates that the firm hires more capital when wage falls, so that
the scale effect (which increases the demand for capital) outweighs the substitution
effect (which reduces the demand for capital). The firm would use less capital if the
substitution effect dominated the scale effect.
SUMMARY
 In the short-run, a profit maximizing firm hire workers up to the point where
the wage equals the value of marginal product of labour
 In the long-run, a profit maximizing firm hires each input up to the point
where the price of the inputs equals the value of marginal product of the input.
This condition implies that the optimal input mix is one in which the ratio of
marginal product of labour and capital equals the ratio of input prices.
Activity
1 Why is the short-run demand curve downward sloping?

2 What mix of inputs should be used to produce a given level of output?
Further Reading
38
Limited.
Lesson Four
Labour Market Equilibrium: Wage and Employment Determination
Introduction
This chapter analyses the properties of equilibrium in a perfectly competitive labour

market. We will see that if markets are competitive and if firms and workers are free
to enter and leave these markets, the equilibrium allocation of workers to firms is
efficient; the sorting of workers to firms maximizes the total gain that workers and
firms accumulate by trading with each other.
We will also analyze the properties of labour market equilibrium under alternative
market structures, such as monopsonies (where there is only one buyer of labour),
monopolies (where there is only one seller of the output) and bilateral where there is
one buyer of labour and one seller of the output.
Objectives
39
1. Determine the equilibrium wage and employment
2. Explain how policies affect equilibrium wage and employment
3. Explain the minimum wage
4. Explain labour market imperfections
Wage-Determination Models
How are wages determined in the market at any given time? The answer depends on
the type of market model that is assumed to exist in a particular situation. There are
several possibilities.
Wage determination in Competitive Labour Markets: Many Buyers, Many

Sellers
Conventionally, the demand for and supply of labour are functions of real wages
(W/P). Real wage is the nominal (money) wage deflated by the CPI. It is the
purchasing power of a money wage.
Equilibrium in the competitive labour market requirement is that aggregate demand

for labour equates the aggregate supply. Thus Nd = Ns = Ld = Ls
Figure 4.0
Ns (w/p)
Nd (w/p) = Ns(w/p)
E*
w
/p
Nd (w/p)
w
/p
N* Units of labour
It is assumed that the aggregate labour demand and supply functions are such that
they produce unique equilibrium at E*. The equilibrium is expected to be stable
because a real wage rate above the equilibrium W/P will generate excess supply and
for a given price level, the money wage will be bid down as workers compete for jobs.
This will increase labour demand and reduce labour supply. This adjustment will
combine until E* is restore. Therefore the direct competition between workers their
willingness to tolerate wage reductions will ensure that E* is stable.
Stability in this model requires that adjustment in the real wages occur through
adjustments in the money wage for a given price.
40
Labour markets do not often operate under competitive conditions because of certain
features that prevent money wages from being flexible. The features result in
rigidities in money wages making it to fail to adjust freely to eliminate excess demand
or excess supply of labour instantly. These features are:-
(a) Institutional rigidities

(b) Misperceptions about changes in wages and price.
(c) Difficulties caused by uncertainities and formation of expectations.
(d) Government regulations
(e) Contracts
(f) Efficiently wage theory
(g) Case of insiders and outsiders:
Institutional rigidities
a) Union explanation
This occurs because unions successfully resist any attempt by firms to reduce wages
or undercut each other in money wages. They resist any attempt by firms to
encourage the process. The unions do however welcome wage increases. Hence
there is downward money rigidity.
Figure 4.1
Ns
w
/p
E*
w
/p
Nd (w/p)
No
Employment (N)
41
The initial money wage employment equilibrium is at (Wo,No). The money wage Wo
is regarded by workers collectively as representing a minimum standard of living
which must be protected at all costs. For a price decrease from Po to P1, real wage
(Wo) will increase and as a result, there will be p1 excess supply of labour. For
equilibrium to be attained, a downward adjustment of wages would be required.
However downward pressure on wages is resisted and disequilibrium will persist
indefinitely.
For any price decrease, money wages do not fall proportionately. This implies that
there will be an increase in the real wage and a fall in employment level. If this is so,
why should unions always resist changes with adverse effects on the employment of
their members and membership?*
(ii) Efficiently wage theory. According to this theory, firms may prefer to set wages
above competitive levels because they argue that high wages would motivate workers
to improve productivity. With such wages, employees would earn economic rents
with the current employer, a thing to which they will strive to maintain by improving
productivity and loyalty so as to reduce chances of layoffs. If all firms find it
profitable to pay wages that are higher than the competitive level, the level of
employment will fall below competitive levels high unemployment rates lowers
probability that an unemployed individual will find a job. So the threat of
unemployment induces a higher efforts on the part of the employed.
iii) Case of insiders and outsiders: When all firms are isolated from labour market
competition the unemployed (outsiders) are not regarded as perfect substitutes for the
existing employees (insiders). Insiders are existing employees, whose position is
protected by existence of significant labour adjustment costs such as training, hiring
and firing costs. Outsiders of whom unemployed are the most important can only
exert an indirect pressure on the wage and job security of insiders because they are
prevented for direct competition by the insiders. Insiders will have undergone on the
job training, the employer and this gives them advantages over the outsiders. Firms
will have a bargaining niche to secure higher wages. The outsiders cannot therefore
bid down the insiders wage in order to secure employment.
Misperceptions about changes in wages and prices
In real life, agents may attach greater significant to nominal wages that real wages.
This may be due to perception of money illustrated. Complete money illusion on the
part of workers involve considering money wages as the important indicator of well-
being. All price movements are therefore ignored. One explanation for this irrational
behavior is that is if the economy have had long periods of price stability workers will
be comfortable with the current money wages. When prices start to fluctuate workers
who are not used to it will persist with their habit of ignoring the price changes since
they will regard them as being relative. Thus an increase in price will be presumed to
42
be offset elsewhere by similar price reduction on other goods as regarded as
temporary hence ignore.
When price instability continues for a long time, money illusion will be considered to
be irrational and workers will recognize the effect changes in price on their real
wages.
43
The role of expectations
In this case, we note the existence of incomplete information which generates the
need for formation of expectations by economic agents. It is considered that firms
know the price for certain and are able to make informed judgment over future prices.
Workers however guesses about the expected price level by relying on their past
mistakes to improve on their forecast about future price levels. So there may be
difficulty in calculating real wages because of uncertainitity about future price levels.
Government may intervene in labour market through minimum wage regulation so

that there is a wage floor below which firms are not allowed to pay. If the wage floor
is above the competitive market level, then it would pose rigidity.
Wage Determination In a Monopsony Labour Market: One Buyer, Many Sellers

A monopsony is a market structure consisting of a single buyer and many sellers of
a good or service. Hence, it may be thought of as a "buyer's monopoly." An example
would be a firm that is the sole employer in a company town, as has been the case in
many mining communities. Similarly, in some farm areas a single food-processing
plant dominates employment for many miles around.
Figure 4.2
A Monopsony Model of Wage Determination
Cost Schedule of Labour Factor
Units of labour factor average cost of labour Total Marginal cost

F factor =(wage rate or cost of of labor
supply price of labour), labor factor, MFC
ACF or S factor,
TCF
1 $5 $5
$7
2 6 12
9
3 7 21
11
4 8 32
13
5 9 45
Figure 4.3 MCF
44
Wage
Average cost of
ACF labor factor ACF, or
Compe- or labor supply S,
titive S available to the firm
wage
W
Monopsony
wage
Wage
MRP = D
T (Firm’s demand for
labor)
Competitive
Monopsony
input
input
L N
O QUANTITY OF LABOUR
Note from the second column of the table that the monopsonist must offer a higher
wage rate or price per unit for all units in order to acquire more labor. (This is thus
the "reverse" of the monopolist in the output market, who must charge a lower price
per unit for all units in order to sell more products.] The result is that the marginal
cost of labor will be greater than the average cost at each input, as shown in the
figure.
The most profitable input level is determined, as always, by the location of the point
at which MCF = MRP. Thus, the monopsonist will employ L units of labor and pay
the lowest possible price for that quantity of labor, namely LT per unit. As a result,
input, as compared to the amount at N, will be restricted. Further, the price per unit,
as compared to the wage NW, will be lower than it would have been if the
monopsonist were a perfectly competitive buyer in the input market.
Wage Determination In Monopoly Labour Market: One Seller, Many Buyers

Suppose a craft union of all skilled workers in a particular trade (such as printing or
plumbing), faces a market consisting of many buyers of that particular skill. The craft
union is then an example of a labor monopoly. What level of wages and what
corresponding volume of labor output will result? The model is illustrated in Exhibit
6.
Figure 4.4
A monopoly model of wage determination
45
S’ (restricted supply)
S (unrestricted supply)
W1
W
Wage
O N1 N
The curves S and D represent the normal supply and demand curves for labor in a free
market. The equilibrium quantity of labor will be at N and the equilibrium wage will
be at W. A monopoly union, however, will seek to restrict the supply of its labor in
order to attain a higher wage for its members. The union will thus shift the supply
curve to the left from S to S'. This will reduce the equilibrium quantity of labor to the
level at N' and raise the equilibrium wage to the level at W’.
This analysis helps explain why some labor unions, especially certain craft unions,
have established long apprenticeship requirements, high initiation fees, and similar
obstacles to entry. The same is true of certain professional associations in such fields
as medicine, law, and engineering. Their motives, at least partly, have been to curb
the supply of labor in the market and thus to boost wage rates. Of course, there are
also unions that do not seek to maximize wages. They may try to maximize the model
in Exhibit 3 would have to be modified reflect .these objectives.
Wage Determination In a Bilateral Monopoly Labour Market: One Buyer, One

Seller
A bilateral monopoly is a market structure in which a monopsonist buys from a
monopolist. The simplest version, which combines the main features of the previous
monopsony and monopoly models, is shown in Exhibit 4.
Figure 4.5
A Bilateral Monopoly Model of Wage Determination
46
S’ (restricted supply)
Monopol S Monopoly
y
Union a Union’s
Preferred Supply
wage
New Of labour
V
Wage
W
U Benefit
Undeterminate
Wage rate
Monopoly
Monopoly MRP = D D Employer’s
Union a
Preferred
demand
wage Of labour
O N1 N
QUANTITY OF LABOUR
Both the buyer and the seller are seeking to maximize their net benefits from the
transaction. Therefore, let us assume that the two parties can agree on a given
quantity to be exchanged, say the amount at M. It follows that the monopsonist will
wish to purchase that quantity far the lower price at U. On the other hand, the
monopolist will want to sell that quantity for the higher price at V. What will be the
transaction price?
Economists have never arrived at a solution to this problem. Many years ago a
fascinating series of controlled experiments was conducted by an economist and a
psychologist at Pennsylvania State University. In the experiments, numerous pairs of
students participated in bargaining for money and services in bilateral monopoly
situations. Out of these and other studies, there has emerged a fair amount of
agreement along the following lines:
1. It is not likely that both the quantity and wage level will be uniquely determined in
a bilateral monopoly model. The reason is easy to see. Suppose the two traders
agree on a quantity, such as M, that maximizes their joint net benefits. Then, the
lowest wage acceptable to the seller is the wage at U. But this gives the whole net
benefit (equal to the shaded area] to the buyer. Conversely, the highest wage
acceptable to the buyer — the wage at V—gives the whole net benefit to the seller.
Therefore, the actual wage cannot be predicted.
47
2. The wage level will be somewhere between the monopsonist's preferred rate at 17
and the monopolist's preferred rate at V. The precise level will depend on the
relative bargaining strength of the two parties.
3. Suppose a wage level of approximately W is negotiated. Management will then
find it profitable to hire more workers — up to the amount at N. This suggests an
interesting conclusion.
In a bilateral monopoly, wages and employment may approximate competitive

levels more closely than would occur under monopoly or monopsony alone.
Labour Market Imperfection
The foregoing models of wage determination and employment disclose a great deal
about supply-and-demand forces in the labor market. But the models are
idealizations, or simplifications, of reality. In the real world, the labor market
contains many complexities and imperfections. As a result actual wage and
employment levels may differ from what the models predict. What are some of the
main sources of labor-market imperfections?
Worker Heterogeneity
Most workers do not sell homogeneous units at labor as the labor-market models
assume. This is because people differ in both natural endowment and in the skills
and experiences they have to offer. Some workers devote extra years to schooling
and to specialized training. In return they earn higher lifetime incomes than those
who never make the sacrifices needed to improve their qualifications. These efforts
at job preparation and training are called "human capital investment." It helps ex-
plain some of the variations in wage and employment levels that exist in real-world
labor markets.
Imperfect Knowledge
Neither workers nor employers have complete information about job opportunities
and job seekers. Consequently, both search.
(i)Worker Job Search Those who are seeking employment weigh the benefits of
looking for work against its costs. The chief benefits are the additional, or perhaps
better, job openings that may be discovered from further search. The main costs are
the sum of two types:
1. The direct expenses (such as traveling costs and the costs of meals away from
home) that are incurred in looking for employment.
2. The opportunity cost of lost income from quitting a job in order to look for work,
or from not taking jobs that are available.
48
As the job search continues, desirable new openings become harder to find.
Discouragement begins to set in as the marginal benefit of further search declines
while the marginal cost rises. When marginal benefit equals marginal cost, further
search is no longer advantageous. At that point the worker stops looking and accepts
employment.
(ii) Employer Job Search Employers adjust to limited labor-market information

quite differently from workers. Two types of management policies help explain why.
First, there is a trade-off between wage costs and search costs. Other things
remaining the same, firms that pay above-average wage rates soon become widely
known. These firms find that they can attract workers more easily and spend less on
recruitment than firms that pay below-average wages. This is one reason why wage
and employment levels in actual labor markets may vary significantly from what
theoretical labor-market models predict.
Second, many companies follow a policy of promotion from within. Such firms place
a minimum dependence on outside recruitment, preferring instead to create their own
internal labor markets. Each firm's internal market contains its own rules governing
job movement within the organization. To the extent that companies rely on such
markets, they limit the ability of workers to move from one firm to another. This
impedes worker mobility and therefore reduces the efficiency of external labor
markets..
Segmented Labor Markets

A third source of imperfection that tends to reduce the efficiency of labor markets lies
in the structure of these markets. Instead of being integrated into a unified whole as
the theoretical models assume, real-world labor markets appear to be segmented. Each
market has its own characteristics that help determine wage and/or employment
levels. Two types that are especially relevant today are the job-competition market
and dual labor market. Both types, proposed by various labor experts, are hypotheses.
They attempt to explain further how some modern labor markets operate.
(i)Job-competition Market This is a labor market in which the number and types of
jobs are determined mainly by prevailing technology. Workers compete with each
other to fill particular job openings associated with existing plant and equipment. (A
factory, for example, needs a specific number of operators, maintenance people,
supervisors, etc. to run its machines.) Wages for these jobs are established largely by
institutional and legislative conditions. These include industry custom, union-man-
agement contracts, and minimum-wage laws. Market forces play a relatively minor
role in affecting wages. The function of job-competition markets, therefore, is to
allocate workers to a given number of vacancies at prevailing, relatively fixed, wage
rates.
49
(ii) Dual Labor Market This is actually two distinct markets. One is a primary
labor market, in which jobs are characterized by relatively high wages, favorable
working conditions, and employment stability. The other is a secondary labor market,
in which jobs, when they are available, pay relatively low wages, provide poor
working conditions, and are highly unstable. Both white-collar workers and blue-
collar workers, many of whom are union members, account for most of the
participants in the primary market. In contrast, the competitively "disadvantaged"—
the unskilled, the undereducated, and the victims of racial prejudice — are confined
to the secondary market.
The Process of Market Adjustment
In a purely competitive labor market, wage and employment levels are determined by
the free interaction of supply and demand. But in the world in which we live, some
labor markets are not purely competitive. Deliberate actions are often adopted by
unions, employers, or government to interfere with normal market operations. The,
reasons are best understood within the framework of certain supply-and-demand
models.
Demand Expansion Model: Increase the Demand for Labor
Figure 4.6
WAGES (hourly)
$20
S
15
10
5 D1
D
0 10 20 30 40
Workers (thousands)
The model illustrates what happens when a union, professional association, or other
group seeks to increase the demand for its members. That is, the group tries to shift
the demand curve to the right, which would result in higher equilibrium wages and
50
employment. In the diagram, the increase in demand from D to D' raises the wage
rate from $10 per hour to $13 and the level of employment from 20,000 workers to
26,000.
The shift in demand is brought about by the use of featherbedding techniques. These
are "make-work" rules or practices designed by unions to restrict output by artificially
increasing the amount of labor or labor time employed on a particular job. For
example, at various times in the past the Painters' Union limited the width of brushes
and the size of rollers.
Supply-Limitation Model: Decrease the Supply of Labor

An organized group of workers may succeed in limiting the supply of labor to a
particular occupation. The effect is shown in Exhibit 2. The actual supply curve is S'
instead of the free-market curve S. As a result, the equilibrium level of employment
is 7,000 workers compared to the free-market level of 10,000. Correspondingly, the
equilibrium wage is $26 per hour compared to the free-market rate of $20.
Figure 4.7
Wages (hourly)
$40 S’
S
30
10
5
D D
0 5 10 15
Workers
Thousands
A number of methods can be used to limit the supply of labor to a particular

occupation. For example:
— Certain craft unions composed of workers in particular trades, such as
electricians and plumbers, have curbed the supply of labor in order to raise wages.
The unions have done this by imposing high obstacles to entry. These include long
apprenticeship requirements, high initiation fees, and closed membership periods
for those seeking membership.
Certain occupational groups have persuaded state legislatures to impose licensing

requirements as a condition for entry. The granting of licenses, controlled by those
already in the field, may be based on educational requirements, test a specified
number of years of supervised experience, and personal interviews. In addition to
51
such specific labor-limiting practices, some unions have sought to restrict the overall
supply of labor in the economy. They have done this by supporting legislation to (1)
curb immigration, (2) shorten the workweek, and (3) assure compulsory retirement.
Industrial-Union Model: Organize All Workers in an Industry
An industrial union consists solely of workers from a particular industry. Examples

are a union of all workers in the automobile industry or a union of all workers in the
steel industry. Such unions seek to organize an industry-wide basis in order to impose
a wage that is higher than the equilibrium wage. Exhibit 3 illustrates this idea.
Figure 4.8
wages (hourly)
$20
W S
15
10
5
D
0 N’
10 20 30 40
Workers
Thousands
The union is able to change the supply curve from its normal shape (which includes
the dashed portion) to WjS. The equilibrium quantity of labor is thus reduced from
20,000 workers to 10,000. Correspondingly, the equilibrium wage is raised from $10
per hour to $15. Stated in somewhat different terms, the graph can be interpreted in
the following way:
At the union-imposed wage of W (= $15 per hour), the quantity of labor offered is WJ
(= 30,000) workers. No labor is offered at less than this wage. In other words, the
new supply curve W/S is perfectly elastic over the range WJ. This signifies that the
industry can hire that much labor at the union wage.
If industry wanted to hire more than WJ units of labor, it would have to offer a
higher wage as shown by the JS portion of the supply curve. However, at higher
wages the quantity of labor demanded by the industry decreases. Thus, only 10,000
workers (represented by the distance ON') will be hired at the wage rate of $15 per
52
hour imposed by the union.
53
Minimum-Wage Model
Unions are not the only groups in society that can affect wages and employment.
Government can too. One of the ways it can do this is by imposing a minimum
wage.
Minimum-wage legislation has a long history, both at home and abroad. The
objectives of such legislation are:
1. To prevent firms from paying substandard wages when labor-market
conditions enable them to do so.
2. To establish a wage floor representing some minimal level of living.
3. To increase purchasing power by raising the incomes of low-wage workers.
Analyzing the Effects of Minimum Wages What are the economic consequences
of minimum wages? Some of the answers are not certain because minimum wages
have many effects and implications. You can gain some appreciation of these by
examining the models in Exhibit 7.
Figure 4.9
Minimum-Wage Model: Raise Workers' Wages
INDUSTRY A
Labor surplus (unemployment)
Wages
W’ S
0 K E L
Workers Thousands
INDUSTRY B
Labor surplus (unemployment)
54
Wages
W’ S Minimum wage
K L
W
0 K E L
Workers
Workers Thousands
In Industry A, the free-market equilibrium wage is at W and the corresponding

equilibrium level of employment is at E. If society deems this wage rate to be "too
low," it will support legislation to raise the rate to, say, W. At this wage level,
employers will want to hire the number of workers equal to the distance WK (=
OK'). However, the number of workers that will offer their labor at this wage level
is W'L {= OL'). The quantity of labor supplied thus exceeds the quantity demanded
at the wage W. Hence there is a surplus of labor—a pool of unemployed human
resources — equal to the amount KL(=K’L)
The same concepts are illustrated in the model of Industry B. However, the amount of
labor surplus or unemployment is less in this industry. The reason is that the labor
supply and labor demand curves are more inelastic than in Industry A.
It is interesting to note that the labor surplus consists of two types of unemployed
people:
1. Those who were previously employed at a wage of W and have become

unemployed at a wage of W.
2. Those who were not previously in the labor force at the wage of W but have
decided to enter it at the wage of W.
Arguments Against Minimum Wages You can readily see from the graphs that
the higher the minimum wage, the greater the labor surplus. For example, if the
minimum wage is raised above the level at W, the pool of unemployed (measured by
the gap between quantity supplied and quantity demanded) will become larger.
55
On the basis of supply-and-demand analysis, opponents of minimum wages conclude
that legally set wage floors cause unemployment. The workers who become
unemployed are those whose productivities are not high enough to allow them to earn
the legal minimum. As a result, they either remain permanently unemployed or seek
work in low-wage marginal industries not covered by the minimum-wage laws. This
depresses wages in those industries still further.
Arguments in Favor of Minimum Wages In response, those who favor wider use
of minimum wages offer arguments such as the following:
— The market for labor is not as competitive as the supply-and-demand models
assume. Instead, employer has a high degree of market power in the hiring of
resources. As a result, employers are able to exploit low-skilled workers by paying
them less than their productivities warrant. Therefore, by raising minimum wages
and by broadening coverage, government can reduce exploitation without causing
unemployment.
-Increases in minimum wages raise consumer purchasing power as well as

production costs. Low-income workers spend practically all of their increased wages,
creating further increases in income and consumption for others. The resulting
expansions in total demand more than offset the rise in production costs. This
stimulates a higher level of employment rather than creating unemployment.
-Enforced higher wages encourage employers to develop better ways of utilizing
their resources. This, in turn, leads to improvements in efficiency and results in
benefits for everyone — business firms, workers, consumers, and society as a whole.
Summary
 There are various theories of wages

 There are various models that can be applied to determine the wage
Activity
Explain the modern theory of wage determination
56
Activity
What is minimum wage
Further Reading
Limited.
Irwin.
Lesson Five
Wage Theories
Introduction
57
Wages are the price paid for the use of labor. They are usually expressed as time
rates, such as a certain amount per hour, day, or week. Less frequently, they are
expressed as piece rates, such as a certain amount per unit of work performed or
Product produced.
Objectives

1. Explain the various theories of wages
2. Explain the various models of wage determination
THEORIES OF WAGES
Different theories have been put forward from time to time to explain how wages are
determined. Early economists attempting to explain how labours share of the
community’s wealth should be determined, proposed the following theories.
1 Subsistence theory of wages:
This is also called the iron or brazen law of wages. According to this theory, labour
power is a commodity whose price is determined by the cost of production i.e. the
minimum subsistence expenses required for the support of the worker and his/her
family in order that continous supply of labour is maintained. The proponents of this
theory argued that wages tend to settle at the level just suffice to maintain the worker
and his family at a minimum subsistence level. If at any time wages exceeded this
level. It is said that workers would be encouraged to many; their numbers would
increase until the larger supply of labour brings down the wages to the subsistence
level as a result of competition between workers for jobs. If on the other hand wages
slipped below the subsistence level, there would be reduction in population through
58
discouraged marriages and deaths due to under nourishment brining a shortage in the
supply of labour. This tendency will continue to operate until wages are raised to
reach the minimum subsistence level. According to this theory therefore, wages
cannot fall below or rise above the minimum subsistence level.
Criticisms
I. Based on Malthusian Theory of population: The said theory is based on the

Malthusian theory population which incidentally ahs a number of shortcomings.
II. Empirically wrong: critics maintain that the theory is not only empirically wrong
but also historically incorrect. Experiences shows that a rise in wages is not
always attended by increase in population, rather it is followed by a decline in the
rate of population growth.
III. Unable to explain causes of wage differentials: The labour market is

characterized by wage rate heterogeneity. If wage were to be equal to the
subsistence level, the wages would in most case be uniform.
IV. One-sided Theory: This theory approaches the population of wage determination
from the side of supply and completely ignores the demand side. It is therefore
unbalanced.
V. Disregard of productivity: according to this theory, wage rate for all workers tend
to be equal to the minimum substitute level. But it doesn’t have to be so because
workers differ in their level of production.
2 Wage Fund Theory:
According to this theory, wages are determined at any given time by the ratio between
the total supply of labour and the wage fund which consists that part of circulating
capital which is set a side by the entrepreneurs for the purchase of the services of
labour. Thus according to this theory, wages can only increase either when wage fund
increases or the workforce goes down. Mill argues that the wage fund can be
increased by saving which is not under the control of workers. This implies that if
workers want an improvement in their wages, their numbers should be reduced.
Criticisms
I. Unscientific: The theory has been disregarded on grounds that it is not scientific
since it rests upon the idea of a fixed fund. Wages are paid out of a firm’s income
and not out of a fixed fund set apart by entrepreneurs for purpose of purchasing
services of labour.
59
II. Differences in wages; This theory cannot explain the existence of wage
differentials among workers. Critics maintain that if wages are not paid out of a
fixed fund and the wage rate depends upon the number of workers employment,
then it follows that wage rate must be uniform throughout the country. This is not
however the case.
III. Homogeneity of labour: The theory rests upon homogeneity of labour when
workers have different levels of efficiency and productivity.
IV. Ignores the influence of Trade Unions in most world, trade unions are able to
effect arise wage levels. The wage fund theory is incomplete to explain the
phenomenon.
V. Ignores productivity. The main defect of the theory is that it completely ignores
the effect of productivity on wages. Productivity is a major factor for wage
compensations.
3 Residual claimant theory.
This theory was developed by an American Economist Francis A. Walker. The

theory maintains that wages are equal to the whole product minus payments to the
other factors of production. The theory regards workers as the residential claimant of
the product of the industry. The theory holds out to workers a possibility of
increasing their wages and thus improving their lot if they worked hard.
60
Criticisms
I. Entrepreneur is the residual claimant: The theory do not explain why labour
should be regarded as the residual claimant to the product of the individual when
in real sense it is the entrepreneur and not the worker who is the residual claimant.
II. One side theory. The theory concentrates on the demand side to the complete
neglect of the supply side.
III. Determination of rents, interest and profits. The proponents of the theory did not
explain how the payment to the other factors of production was to be arrived at.
4 MARGINAL PRODUCTION THEORY
This theory states that the price of a factor is determined by its marginal productivity.
The wages in a competitive market tend to be equal to the marginal product of labour.
Marginal productivity is an addition to total productivity resulting from the
employment of an additional unit of labour. The theory assets that no worker under
conditions of perfect competition can expect to receive wages above the above the
value of its marginal product of labour are equal is reached. In a competitive market,
paying factors of production according to their marginal productivity means an
efficient allocation of factors of production in a productive process.
Criticisms
I. The theory assumes that all units of labour are not homogenous, so that any
worker is as productive as the other factor. This is not five since workers have
different attributes.
II. It assumes that the amount of labour used in the production can be continuously
varied. This may not be always time and in the circumstances the use of labour
cannot be pushed up to the point when its marginal productivity becomes equal to
wage rate.
III. Assumes perfect mobility of labour which is not realistic.
IV. Theory is valid only under perfect competition which does not exist. It breaks
down the real life.
V. The theory implies that employment can be increased by reducing wages so that
more labour is employed so as to make wages equal to marginal production. The
argument is fallacious taking into account downward wage rigidity and may not
apply in the case of the national economy. Total employment in a country depends
61
on effective or aggregated demand which explains the economy’s productive and
absorptive capacities.
5 MODERN THEORY OF WAGES
This is also called the market theory of wages or the demand and supply theory.
According to this theory, wages are determined by the interaction of the forces of
demand and supply in the labour market at any given time. But the labour market is
not perfect since it is characterized by monopoly, monopsony and bilateral monopoly
conditions (trade unions, employer’s associations and government intervention) which
create imperfection in the market.
Further Reading
Limited.
Irwin.
62
Lesson Six
Human-Resource Development
INTRODUCTION
The theory of compensating differentials suggests that wages will vary among worker
because jobs are different. Wages will also vary among workers because workers are
different. People bring into the labour market a unique set of abilities and acquired
skills or human capital. This chapter discusses how we choose the particular set of
skills that we offer to employers and how our choices affect the evolution of earnings
over the working life.
We acquire most of our human capital in school and in formal and informal on-the-
job training programs. The skills we acquire in schools makes up an increasingly
important component of our stock of knowledge.
The chapter analyses why some workers obtain a lot of schooling and other workers
drop out at an early age. Workers who insist in schooling are willing to give up
earnings today in return for higher earnings in the future.
This chapter examines the impact of differences in set of worker’s abilities and
acquired skills or human capital on the dtermination of wages and employment.
Objectives

1. Explain the schooling model
2. Explain what determines the decision to go for further studies or not
63
Adam Smith in The Wealth of Nations (1776) observed, investment in human re-
sources yields benefits to the individual as well as to the nation. That is, it yields
private as well as social returns. These returns are based on abilities and skills that
are obtained from acquisition of knowledge.
Formal education, of course, is only one method of improving people's knowledge

and skills. Other methods consist of various kinds of job training and work
experience programs. All of them together constitute what may be called human
resource policies. These may be defined as deliberate efforts undertaken in the
private and public sectors to develop and use the capacities of human beings as actual
or potential members of the labor force.
THE SCHOOLING MODEL
Some workers obtain a lot of schooling and other workers drop out at an early age.
Workers who insist in schooling are willing to give up earnings today in return for
higher earnings in the future.
We do not stop accumulating skills and knowledge the day we finally leave school.
Instead, we continue to add our human capital stock throughout much of our working
lives. Here we analyze how workers choose particular part for their post-school
investments and investigate, how these choices influence the evolution of earnings
over the life cycle.
We assume that the worker chooses the level of human capital investments that
maximizes the present value of lifetime earnings.
P.V. of payment of y kshs is given by
64
p.v. = y/(1+r)
where r = rate of interest/ discount.
Assume that workers acquire the education level that maximizes the present value of
lifetime earnings. Education and other forms of training are valued only because they
increase earnings.
The diagram below illustrates the economic trade-off involved in the workers
decision. It shows the age-earnings profile i.e. the wage path over the life cycle)
associated with each alternative.
Figure 6.0
W
WCOL
WHs
18 22 65 Age
Upon entering the labour market, high school graduates earns wHs annually until
retirement age at 65. if the person chooses to attend college, he gives up wHs in
labour earnings and incurs direct cost of H to cover tuition, books and fees. After
graduation, he earns Wc0l annually until retirement.
The diagram indicates that a worker faces two different types of costs if he goes to
college. A year spent in college is a year spent out of the labour force. This is the
opportunity cost of going to school. It is given by wHs. The student also has out-of-
pocket expenses of it for tuition, books, and a variety of other fees. Employers who
wish to attract a higher educated (and presumably move productive) workforce will
have to offer higher wages, so that Wc 0l > wHs. The high wage paid to worker’s with,
more schooling is a compensating differential that compensate workers for their
training costs.
Present value of age – earnings profiles

PV of the earnings stream if the worker gets only a high school education is
P.VHs = WHs + WHs + WHs +….. + WHs
65
(1+r) (1+r) (1+r)n
The P.V of the earnings stream if the worker gets a college diploma is
P.Vcol = - H – H – H - H + Wcol + Wcol + Wcol + - Wcol
(1+) (1+)2 (1+)3 (1+)4 (1+) (1+)5 (1+)6
Direct cost of attending college College earning stream
A person’s schooling decision maximizes the PV of lifetime earnings. Therefore the

worker attends college if the PV of lifetime earnings when he gets a college education
exceeds the PV of lifetime earnings when he gets only a high school diploma.
Pvc06 > PvHs
Eg numerical example
Suppose a worker lives two periods and chooses from two school options, he can
choose not to attend school at all in which case he would earn 20,000 in each period.
P.v0 = 20,000 + 20,000
(1+r)
He can also choose to attend school in the first period, incur 5,000 worth of direct
schooling costs and enter the labour market in the second period earning 47,500
P.v = -5,000 + 47,500
(1+r)
Suppose r = 5%
Pv0 = 39,048 Pv1 = 40,238

The worker chooses to attend school.
NB. If r = 15%
Pv0 = 37,391 Pv1 = 36,304
The workers would not go to school
From the above, the rate of interest plays a crucial role in determining whether a
person chooses to go to school. The higher the r the less the lively a worker will invest
in education. This is because a worker who has a high discount rate attaches a very
low value to future earning opportunities. Because the return to an investment in
education are collected in the far-of future, persons with high discount rates require
less schooling.
The rate of discount depends on how we feel about giving up some of today’s
consumption in return for future rewards – or own time preference. Some people are
present oriented and some are not. Persons who are present oriented have a high
discount rate and would be less likely to invest in schooling. Poorer families have a
higher rate of discount than wealthier families.
66
SUMMARY
 The wage-schooling locus gives the salary that a worker earns if he or she
complete a particular level of schooling
 Workers choose the point on the wage-schooling locus that maximizes the
present value of lifetime earnings. In particular, workers quite schooling when
the marginal rate of return to schooling equals the rate of discount.
Activity
Discuss how the wage-schooling locus is determined in the labour market, and why it
is upward slopng and concave
1 Explain how education contribute to wage defererntial in the labour market
Further Reading
Lesson Seven
67
Occupational wages differentials
INTRODUCTION
Earnings differentials among workers can be analyzed on the basis of many different
characteristics such as occupation, industry, geographical area, genda and race. Of
these different dimensions of the wage structure, occupational differentials are one of
the most important because they capture the influence of several of the principal
determinants of earnings in the labour market. Chief among these are differences
among workers in levels of education and training and differences among jobs in
terms of various noneconomic attributes such as status, prestige, and the quality of
working conditions.
Objectives

1. Explain the compensating wage differentials
2. Explain the effect of risk in wage determination
Compensating Wage Differentials
Occupations differ one from another in terms of many characteristics, such as

education and training required, the pleasantness or unpleasantness of the work, the
status and prestige in which the occupation is held, the probability of success in that
line of work, and the level of wages in the occupation. Adam smith’s greatest insight
was to realize that people choose an occupation based not on the wage alone, but on
the whole package of attributes, both negative and positive. Smith postulated that each
worker compares the total of the advantages and disadvantages of each occupation,
and chooses the one yielding the highest level of net advantages. Since some
occupations are more desirable than others if wage rates were equal, workers would
crowd into the desirable occupations and shun the undesirable ones. As Smith
deduced, therefore, for equilibrium to occur in the labour market, the wage rate must
68
rise in the undesirable occupations and fall in the desirable occupations until the total
advantages and disadvantages are equalized across occupations. Differences in rates
of pay among occupations thus represent compensating wage differences in the sense
that they equalize the net attributes of each occupation.
In equilibrium, occupational wage difference will exist because of the following

reasons:-
A Job Attributes
Many factors affect the attractiveness of one occupation relative to another. Adam
Smith referred to these considerations as the agreeableness or disagreeableness of the
occupations. Some occupations have very agreeable features such as high social status
flexible working hours, or room for considerable autonomy and creativity. Examples
are doctors, professors, and singers. Other occupations have very disagreeable
features such as unpleasant working conditions, monotonous or tedious work, or low
social status. Examples include butchery, assembly-line worker and janitor. While
these factors do not directly affect the monetary return derived from employment in
an occupation, they do nevertheless have a strong influence on its relative
attractiveness to people.
To illustrate the effect of job attributes on wage differentials, assume occupations A

and B are identical in every aspect except that occupation B involves work that is of
low social prestige. If the wages in occupation A and B were equal, everyone would
seek employment in occupation A and would refuse to consider work in occupation B.
To achieve an equilibrium in the labour market, the wage must rise in occupation B
relative to A until it is just high enough to compensate for the negative attribute of
low prestige. The size of this compensating differential is illustrated graphically
below.
Figure 7.0
69
The W1-W0 difference represents the dollar value per hour necessary to just
compensate for the negative disutility arising from this undesirable feature of the
work. While a negative attribute must be balanced by a higher wage, an occupation
that possess a positive or agreeable attribute must pay a money wage lower those
other occupations if the advantages and disadvantages are to be equalized. In this
case, the supply curve s1 in the diagram would lie below the line of equal wages.
Equilibrium will occur at point X where the demand curve DB intersects the supply
curve SB. The compensating wage differential is W1 –W0. The broken line at W0 =
1.0 is where the wage rates in the two occupations are equal. The supply curve SB is
perfectly elastic at the wage W1, indicating that at any wage lower than W1, no one
would be willing to work in occupation B.
B Differences in the costs of acquiring skills. Occupations differ in the amount

of money that individuals spend in order to acquire the skills necessary to enter an
occupation. The fact that an occupation requires a higher human capital investment
will result in workers requiring a wage premium in order to be induced to enter that
occupation.
C Differences in internal rates of time preference. People differ in their

internal rates of time preference. Because of this, the equilibrium wage level will
depend on the state of demand and this affects the size of the premium to be paid.
D Differences in tastes for non-wage aspects of jobs. It is noted that people

differ in their tastes. What is highly attractive aspect of a certain occupation for a
person may be substantially less attractive for another when workers differ in their
tastes for non-wage aspects of jobs, the supply curve to any occupation will be
70
upward-sloping. In this case, the equalizing difference will be negative when demand
is to but positive when demand is high.
E Occupational variability of earnings; two occupations may have the same

average annual wage but differ in the variability of earnings within the occupation. A
person who chooses the profession with high wage variability is subjected to a
considerable risk because of not being able to determine with certainty however
he/she will fare the risk of unemployment and job security also vary between
occupations. People are risk averters or risk lovers. Thus people who are less risk
averse will be willing to enter a given occupation at relatively low compensation for
risk (i.e. at a lower relative wage) than those willing to take risks.
F The Risk
Suppose there only two types of jobs in labour market. Some jobs offer a
completely safe environment, and the probability of injury in these jobs is equal to
zero. Other jobs offer an inherently risky environment and the probability of
injury in these jobs is equal to one. We will assume that the worker has complete
information about the risk level associated with every job. In other words, the
worker knows whether he or she is employed in a safe job or a risky job.
Workers care about whether they work in a risky job or safe job. And they also
care about the wage (w) they earn on the job. We can the write the workers utility
function as
Utility = f (w, risk of injury on the job)
The only way to persuade the worker to move the riskier job and hold his utility
constant is by increasing his wage. The worker earns a wage of W0 if he chooses
to work in a safe environment and gets W1 if he chooses to work in a risky
environment. The workers reservation price is the given by ∆W = W1-W0
The Supply Curve to Risky Jobs

The supply curve tells us how many workers are willing to offer their labour to the
risky job as function of the wage differential between the risky job and the safe
job. Because we have assumed that all workers dislike risk, no worker would be
willing to work at the risky job when the wage differential is zero. As the wage
differential rises, there will come a point where the worker who dislikes risk the
least is “bought off” and decides to work in the risky job. This threshold is
illustrated by the reservation price ∆WMIN in figure-------. As the wage differential
between the risky job and safe job keeps increasing, more and more workers are
bribed into the risky occupation, and the number of workers who choose to work
in risky jobs keeps rising.
Demand Curve for Risky Jobs
71
Just as workers decide whether to accept job offers from risky firms or from safe
firms, a firm must also decide whether to provide a risky or a safe work environment
to its workers. The firm’s choice will depend on what is more profitable.
From the face of it, it would seem the firm should provide a safe environment- after
all; the firm could the pay a low wage to attract workers. This argument, however,
ignores the fact that removing the hazards from the workplace is likely to be quite
expensive. The firm has to allocate labour, resources, and materials to produce a safe
environment-diverting these resources from production of output. The firm therefore
may be more profitable when the work environment is risky.
The economic trade-off faced by the firm should be clear. It could offer a risky
environment, where the firm must pay higher wages, or it could offer a safe
environment, where the firm saves on labour costs but where resources must be
diverted to producing safety. This trade-off suggests that the firm will be dissuaded
from offering a risky environment to its workers when it must pay a very high wage
premium to attract workers. The firm will then opt to make the necessary investment
and improve safety in the workplace.
Different firms will typically have different technologies for producing safety. Some
firms find it easy to produce safety, whereas others find it very difficult. Universities
for example do not have to allocate many resources to the production of safety in
order to provide a safe environment for the staff and students. In contrast, coal mines
find it much more difficult to produce safety. The productivity gains associated with
offering a risky environment in coal mines is probably substantial.
Suppose that the wage differential between risky jobs is very small. Few firms will
the find it worthwhile to make the requisite investments to remove the hazards from
the workplace. Almost all firms will then choose to offer a risky work environment
and the demand for labour by risky firms is quite high.
As the wage differential between risky jobs and safe jobs rises, some firms will begin
to find that it is cheaper to make the work environment safe (rather than pay high
wages). As the wage differential rises even more, additional firms find it profitable to
offer a safe environment. In short, the larger the wage differential between the risky
job and the safe job, the smaller the number of firms that will choose to offer a risky
work environment, and the smaller the quantity of labour demanded by risky jobs.
The labour demand curve for risky jobs, therefore, is downward sloping.
Figure 7.1
72
The market compensating wage differential and the number of workers employed in
risky jobs are determined by the intersection of the market supply and demand
curves, as illustrated by point P in figure-----. The compensating wage differential
received by workers in risky firms is (w1-w0)*, and E* workers are employed in
these jobs.
Summary
The compensating wage differential can affect the wage late in the labour market.
Risk I an important element in the labour market and it affect the wage rate and the
level of employment.
Activity
73
1 What is risk in the labour market?
2 Discuss the implications of risks in the labour market.
Refernces
Limited.
Irwin.
74
Lesson Eight
Labour Market Discrimination
INTRODUCTION
We will demonstrate that differences in earnings and employment opportunities may

arise even among equally skilled workers employed in the same job simply because
of the workers race, gender, national origin, sexual orientation, or other seemingly
irrelevant characteristics
These differences are often attributed to labour market discrimination. Discrimination

occurs when participants in the market place take into account such factors as race
and sex when making economic decisions
There is a great variety of occupations which women have begun to claim as fields for
individual effort from which no intelligent, refined man who views things as they
really are would seek to exclude them.
More than 2500 years have elapsed since the first quotation above was written. Yet
there is evidence that women are still a long way from job equality with men. Despite
substantial progress, various studies show that women often earn considerably less
than men in the same occupational category. (See the table in Exhibit 8.)
Much the same is true of certain minority groups. Blacks, Asians, homosexuals, and
members of other groups have long been victims of discrimination in employment.
Let us look at some of the effects of job discrimination, and some of the' effects that
would occur if it were eliminated.
Objectives

1. Explain the causes of wage differentials
2. Explain models of wage differentials
3. Differentiate between occupational and regional wage differentials
75
What are the causes of wage discrimination?
The economic analysis of discrimination is based on the premise that significant wage
and employment differences persist between groups in the labour force that are not
justified by difference in productivity and human capital investment. labour market
discrimination is therefore and do exist when workers with identical productive
capabilities receive different rewards for their effort. This means that wage
differentials are greater than product into differential. Employment discrimination is
when black people for example bear a disproportionate burden of unemployment.
Occupational discrimination occurs when females, for example, are restricted from
entering certain occupations, and/or crowded into others, despite equal capabilities
between them and males.
At theoretical level, there are two main schools of economic thought regarding
discriminations. One is the neoclassical theory stemming from the World of Becker
(1957) which is based on the notion that prejudice is expressed in discriminatory
tastes on the part of employers, workers and consumer. The alternative is the
segmented labour market approach (two-market model), which can trace its heritage
back to theory of non-competing groups in the work of Mill (1885).
THE NEOCLASSICAL TASTE MODEL
The modern economic analysis of discrimination in the labour market is founded upon
seminal work of American Economist Becker (1957). 1 Becker integrated the concept
of discrimination with mainstream neoclassical microeconomic analysis by suggesting
that one group has a “taste” for discriminating against another group and that this taste
was a factor into utility function. He identified a number of groups that could be
ascribed to a taste for discrimination: workers, employers and consumers. However,
most of the neoclassical analysis of discrimination has centred on the employer as the
agent of discrimination. Accordingly, we shall set the neoclassical employer taste
model.
76
Employer discrimination
In the standard neoclassical theory, we assume that firms are profit maximizers. In
other words their utility is a function of profit. U=f(II) and workers’ utility is a
function of wage incomes and leisure U = F(W,L). Discrimination is introduced by
allowing firms to have “a taste for discrimination. In this theory it is argued that
employers have a taste of for discrimination in the sense that their utility is adversely
affected by employment of, and wages paid to, the group being discriminated against,
in this case we assume females (F). Although the monetary cost of employing males
and females are given by their wages, Wm and Wf respectively, the disutility
experienced from hiring women affects the net cost such that
WF = WF (1+d)
Where d is the discrimination coefficient. If an employer favours women workers, d

will assume a negative value. If the firm is completely indifferent between males and
female; when it comes to hiring workers, d=o. Yet if an employer discriminates
against women then d will be positive.
As firms employ more and more female workers, up to a maximum of 100%, they
require more profit to compensate them for the associated disutility.
Figure 8.0
Wage ratio SF
Wf/Wm
1.0
D1
0.75
0.66
D2
D3
O L0 L3 L2 L1 Employment
77
The horizontal portion of demand curve represent the labour demand of non-
discriminating employers(d = 0) since, if majority and minority workers are assumed
to be equally productive, non-discriminator would be willing to hire minority workers
whenever Wf ≤ Wm. Beyond the kink, the remaining employers have increasing
amounts of prejudice (d>0) and would only hire minority workers at successively
lower relative wages. Finally, if same minority employers practiced favourism
towards minority workers, then (d < 0), and the initial of the demand curve would
then lie above 1.
The diagram shows a situation where a conventionally sloped female labour supply
curve (SF) encounter three different sets of demand conditions. The first, D1
represents a situation where the lack of any discrimination. It identifies a maximum
potential employment level L1, at wage rates equal to those of male workers hence
wf/wm = 1.
If a certain proportion of employers discriminate against women in their hiring

practices this gives the demand curve for female labour, Kink at employment level
LO. Consider D2 non-discriminating firm’s demand conditions apply to LO; beyond
Lo, prejudiced employers require a wage differential to compensate them for the loss
of utility arising from the hiring of more female workers, discrimination creates a gap
between wages of men and women. In the example female workers would earn only
three of what a male worker learns (WF/WM = 0.75). In actual female employment
level of L2 is than the potential maximum because of discrimination the labour
market. The higher the discrimination the wider the gap.
Even though proportions of firms are prepared not to discriminate against employing
women, they will pay the going market rate ⅔ of a male worker’s wage rate in the
case of D3. It is the case that female wages have increased overtime relative to men’s
and the earning gap has narrowed, this implicate a change in employer tastes. Such a
change could be brought about by competition from less discriminating firms, or it
could be due to greater awareness of the worth of women workers acquired from
information, direct experience of enforcement of equal part opportunities legislation.
A fundamental assumption of this model is that male and female workers are equally
productive. An important prediction which falls out the employer taste model is that
competitive labour and product markets would ensure that discrimination is only a
short run phenomenal. More prejudiced employers will employ a high proportion of
male workers than their more egalitarian rivals. This means that they face higher
wage bills than those firms that employ agreement proportion of equally productive
females since Wm >Wf. Egalitarian firms will face lower unit labour costs and will
make greater is and/or be able to charge lower prices than their discriminating.
Higher IIs attract other non-discriminating firms into the market and should entice
existing firms to change their recruitment policies in favour of women workers. New
entrants will increase output and depress prices and II s. Discriminating firms must
78
therefore either employ female workers or face making losses, declining market
shares and eventually giving out of business.
New entrants and altered hiring policies increase the demand for female workers, a
shift from D3 to D2. This increases female employment and raise women’s wage rates
relative to those of men. The sex earnings gap narrows as competitive forces tend the
labour market towards the equality Wf = Wm. Discrimination can only exist in the
short run if the competitive mechanism fails to operate effectively as in the case of
labour market imperfections.
Condition under which discrimination can persist even in the long run:-
 If firms possess a degree of market power in an oligopolistic market structures.
 If firms do not aim at maximizing IIs, discrimination could be tolerated as a drain

on IIs.
 The erosion of discrimination competition could be a lengthy a incomplete

process because of the adjustment (hiring and firing) costs associated with
replacing male with female workers to take advantage of the fact that Wm >Wf.
 Prospects of reducing discrimination may well vary over the business cycle i.e.
recession and boom.
 Another aspect of sex discrimination is based upon what is perceived to be

women’s strategic weakness in the labour market, their comparative immobility.
Criticisms
 Why would decades of even imperfect market which fail to erode wage and
employment differentials?
 Does the employer taste model accurately reflect fact that large-scale oligopolistic
firms, which do much of the activity in our economies, have divorced ownership
from control and operate within a framework of equal opportunities legislation.
 One is assigning discriminating taste to personnel department practices rather than

the individual capitalists.
 The model does not explain the causes of discrimination. It is only an analysis of
it labour market effects of discrimination.
79
 The model addresses problems of wage discrimination whereas employment
discrimination may be the more significant labour market result of prejudice. If
employer’s office a structured hierarchy of jobs at different levels reflecting
different productivity levels, discrimination against women will ensure women are
employed in the job structure below their potential. Thus if the wages for females
depend upon their productivity and the discrimination they encounter; MRP f = Df.
Therefore in order to obtain and maintain employment at a given level in the job
structure, women must always work to a higher standard than their male
colleagues and to a higher standard than hierarchy actually requires.
Labour Market Segmentation Approach
This theory maintains that we should move away from the concept of the competitive
labour market and view the market as being split into a variety of constituent parts,
which interacts imperfectly with each other to only a very limited extent. Variants of
the segmented market approach include; the dual labour market hypothesis which
identifies primary and secondary sectors of employment; the job crowding
hypothesis which identifies predominantly male and mainly female occupation in the
case of sex discrimination; and the insider – outsider theory which splits the labour
market into those who work or are unemployed unionised and those who are
unemployed or who are non-unionised workers.
Job crowding hypothesis
According to this theory any wage differentiate male and female workers is due to the
fact that men and women art essentially in different jobs. Discrimination could
equally result if females are excluded from jobs which they have the ability to do. If
such jobs tend to be high wage jobs then this will create wage differentials between
males and females. Thus job segregation occurs as a result of women being faced
with difficult access to certain jobs, especially the professions. This does not need to
take the form of reaching trade unions and under veto
This is when a section of the workers are restricted from entering certain occupation
and and/or crowded into other areas despite existence of comparable capabilities
between to the two groups of workers are job segregation occur as a result of female
workers being faced with difficult access to certain jobs making them to be crowded
into the remaining more easily accessed jobs. Job segregation and crowded might
reflect female choices geared towards combining child bearing and rearing
responsibilities with less demanding to mobility jobs.
Figure 8.1
80
S0
S1
S0 S2
Wage
Rate
W1
W1
WE
WE
D
D
LO Employment
L1 LO Employment F Jobs
M jobs
81
In a competitive market situation, the interaction between theories of demand and
supply will lead identical equilibrium wage in both markets. When discrimination in
terms of entry criteria sets in the positive number of female workers in potential male
jobs go down shifting the supply curve upwards to the wage rate goes up and
employment levels reduces to L1. The female workers relocates to the easily and
increases supply to S2. Wage rate is W2 on hiring women; the entry criteria may take
the form of lengthy training or an employment history which inadvently excludes
access to a disproportionate number of women. Women are thereby crowded into the
remaining more easily accessible jobs.
A job segregation and crowding might reflect female choices geared to combining
child female choice geared to combining child bearing and rearing responsibilities
with less demanding low mobility jobs.
Dual labour market hypothesis (Two-Market Model)
In this theory, it is considered that the labour market is segmented into primary and
secondary sectors. Jobs in the primary market or sections deemed to possess services
of the following characteristics;-
 High wages
 Good working conditions
 Employment stability
 Chances of advancement
 Equity and due process in the administration of workers, job in the secondary
market, in contrast, tend to have low wages and fringe benefits.
 Poor working conditions.
 High labour turnover
Little chances of advancement and often arbitrary and conspicuous suspension. The
dual labour market hypothesis would suggest that male female differential reflect the
fact that male workers are by and large involved in the primary market, whereas
female workers tend to dominate the secondary will.
An opportunity for discrimination exists when a market can be divided into

homogeneous submarkets. Price and quantity can then be established in each
submarket through the separate interactions of supply and demand. An illustration of
this is shown in the two-market model of Exhibit 8.
Figure 8.2
Sex Differences in the Labor Market
(a) Primary market Males(m) (b) Secondary market Females (F)
82
Sm
Sm+f
WAGE RATE
Wm Sf
WAGE RATE
Wm+f
Wf Wf
O O D
QM QM+F QF
NUMBER OF WORKERS NUMBER OF WORKERS
Figure (a) represents a primary labor market for males. Figure (b) depicts a secondary
labor market for females. (The same model could be used to analyze discrimination
between whites and blacks, skilled and unskilled, or other competing groups.)
In Figure (a), the demand curve D for labor in the primary market intersects the
supply curve of males, SM. This results in an equilibrium wage rate for males at W M
and an equilibrium quantity of male employment, QM.
Because women are to some extent excluded from the primary market, they must
seek employment elsewhere—namely, in the secondary market represented by Figure
(b). In this market, occupations are less productive than in the primary market. As a
result, Figure (b) shows that the demand for women's services is less, and the supply
of females looking for jobs is smaller, than the demand for and supply of men's
services in Figure (a). The economic consequence of this is that the equilibrium wage
rate for females, WF, and the equilibrium quantity of female employment, Q F, are less
than WM and QM.
How can this situation be corrected? The ideal solution would be to eliminate
discrimination by permitting women to compete with men in the primary market. If
this were done, the supply curve of females SF in Figure (b) would be added to the SM
curve in Figure (a). This would yield a new total market supply curve of males and
females, SM+F. The secondary market would no longer exist.
Favorable Effects of Eliminating Discrimination
83
As you can see from Figure (a), the elimination of discrimination would have several
major effects.
First, total employment would be raised from the level at QM to the level at QM+F.
This would also lead to increased production because women would be employed in
more productive jobs than before. Consequently, society would benefit by receiving
a larger volume of output.
Second, the equilibrium wage of females would increase, and the equilibrium wage
of males would decrease, to the level at WM+F. Further, the increase in wages
received by women would more than offset the decrease in wages received by men.
Society, therefore, would experience a net monetary gain.
The increased wages received by women would not come from the reduced wages
received by men. It would come from the gain in productivity and the additional
output that would result from the elimination of discrimination.
Summary
Activity
3 What is the discrimination coefficient?

4 Discuss the implications of employer discrimination for the employment
decisions of the firm for the profitability of the firm.
Refernces
84
Limited.
Irwin.
85
Lesson Nine
Labour Unions
Introduction
Trade union may be able to secure high wages, better working conditions, protect
workers from arbitrary treatment by management and other economic gains for its
members.
Objectives

1. Explain collective bargaining
2. Explain how union influences wages in the labour market
3. Explain the economic impact of trade union
Unions and Management: Collective Bargaining
What is a union? It may be defined as an organization of workers that seeks to gain a

degree of monopoly power in the sale of its services. In this way it may be able to
secure higher wages, better working conditions, protection from arbitrary treatment
by management, and other economic gains for its members.
The chief objective of unions is thus to enhance the status of workers. That goal is
largely achieved through collective bargaining. This is a process of negotiation
between representatives of a company's management and a union. The purpose is to
arrive at a set of mutually acceptable wages and working conditions for employees.
Collective bargaining as it is known today came about as a result of the National
86
Labor Relations Act of 1935. This law is the most important piece of labor legislation
in American history. It was the culmination of many decades of struggle and hard-
ship by workers to achieve union recognition in labor-management negotiations.
Today's collective bargaining agreements differ greatly in their scope and content.
However, practically all agreements deal with at least three fundamental issues:
(i) Wages and other benefits
(ii) Industrial relations
(iii) Settlement of labor-management disputes
Wages and Other Benefits

Such packages are generally composed of several parts.
Basic Wages
First, these are the payments received by workers for work performed. These
payments, called basic wages, may consist of time and/or incentive payments.
Time Payments Most workers in American manufacturing are paid on the basis of
time—by- the hour, day, week, or month. They also receive extra compensation for
work done during nights, weekends, and holidays.
Incentive Payments A large minority of American manufacturing workers receive

their basic compensation through incentive payments. These may be in the form of
wages, commissions, bonuses, etc. They are tied to some measure of company
performance such as profit or productivity. Incentive systems of this type are
sometimes called gain-sharing plans.
Gain-sharing plans offer advantages both to participants and to society:

improved Efficiency Workers are encouraged to increase their productivity because
they stand to benefit from the gains.
Fringe Benefits
Another important part of collective bargaining agreements concerns fringe

benefits. These are monetary advantages other than basic wages that are provided
by employers for their employees. Examples- include:
Time Off With Pay—the number of nonworking days per year (holidays, sick-leave
days, personal-business days, etc.) that workers can take without loss of wages.
Insurance Benefits—the proportion of workers' life-and health-insurance premiums

paid by employers.
Pensions—the percentage of payments to retirement plans paid by employers.
87
Income Maintenance—the proportion, or in some cases the level, of employees'
normal pay that they will receive from the company in the event of economic
layoffs or job termination.
Industrial Relations
A second major area of collective bargaining pertains to industrial relations. It
deals with the rules and regulations governing the relationship between union and
management. There are, of many aspects of industrial relations. Those that
especially important today from an economic point of view concern (1) restricting
membership and output and (2) employment security.
Restriction of Membership and Output

One of the chief goals of unions is to obtain higher incomes for their members. Some
unions try to achieve this goal by restricting membership or by restricting output.
If a union can limit its membership, it may be able to create a scarcity of a particular
kind of labor. A union can control membership in several ways. These include: (1)
varying apprenticeship requirements; (2) sponsoring state licensing for those in the
trade (examples are barbers, electricians, and plumbers); and (3) varying initiation
fees.
If a union can limit its members' production it can increase the demand for its
workers and thereby negotiate higher wages. How might a union restrict output?
Three methods are typically used: (1) shortening the working day; (2) limiting
output per worker; and (3) resisting the introduction of labor-saving technology.
Thus, on the one hand, management seeks to increase profits by raising productive
efficiency. On the other hand, unions seek to improve earnings and working
conditions for their members. Sometimes the means used to achieve these objectives
may conflict. When they do, the methods of resolving them often play an important
role in collective bargaining negotiations.
Employment Security: The New Industrial Relations

Business executives used to believe that because they were dealing with uneducated
workers, the only way to improve productivity was through "scientific
management." This meant that complex jobs had to be broken down into a number
of simple, repetitive operations, and that new equipment had to replace obsolete
machinery whenever possible.
Most unions accepted this view and saw their relation with companies as adversarial.
The function of union leaders was to protect jobs and wages, even at the cost of
imposing restrictive production rules and practices.
88
Since the 1970s, some of these attitudes have changed. Under the new system, the
adversarial relationship in some industries has been de-emphasized. Instead the
approach to employment security in these industries consists of developing union-
management cooperative agreements. These are designed to accomplish such
objectives as the following:-
Restraining workers. Some firms have established special training programs for
union members. Laid-off workers have been taught new skills and employed workers
have been taught upgraded skills. Several studies report that many of the retrained
workers have subsequently found jobs in their own or in other industries.
Encouraging worker participation. Workers are becoming more involved with

decisions on the plant floor. Committees of workers, quality circles, have been
formed within companies to discuss ways of improving production methods, job
satisfaction, and productivity. In return, management has agreed to be more open
with workers, to share the benefits of participative decision making, and to seek ways
of improving job security.
Providing lifetime employment. Some union-management negotiations have

explored the feasibility of “lifetime” job guarantees. It appears, however that such
policies, when adopted, have usually been limited to select groups of workers with
high seniority.
Is this newer approach to industrial relations effective? There is evidence that it is.
Studies have shown that in many firms that have adopted employment security
programs, improvements in morale, productivity, and therefore in company
profitability have been significant. Nevertheless, there are still strong elements of
resistance to change.
Some come from managements and some from unions, because both are reluctant to
share responsibility and power. It may be years, therefore, before the "new" industrial
relations becomes widespread in American industry.
Settling Labor-Management Disputes
Despite efforts at achieving greater cooperation, union-management negotiations

sometimes break down. How are they resolved? One possibility is by a strike. This is
a mutual agreement among workers to stop working, without resigning from their
jobs, until their demands are met.
A strike, however, is a costly weapon that unions do not use lightly. Indeed, since
1935, the amount of working time lost on an annual basis because of strikes has
averaged less than ½ percent of total labor-days worked. This is far less than the
proportion of time lost from work because of the common cold.
89
Accordingly, unions need alternative means of settling disputes with management.
The most common means are arbitration and mediation.-
Arbitration is used to resolve union-management differences that sometimes arise

over the interpretation of one or more provisions of an existing collective-bargaining
contract. The two sides select a third party, called an arbitrator, whose decision is
legally binding. After hearing the evidence from both sides, the arbitrator issues a
decision. It is based not on what the arbitrator believes to be wise and fair but upon
how he or she understands the language of the contract to apply to the case at hand.
Thus, an arbitrator is like a judge. An arbitrator relates the case to the contract, just as
a judge relates a case to the law.
Mediation, sometimes also called conciliation, is a means by which a third party, the
mediator, attempts to reconcile the differences between contesting parties. Mediation
is commonly employed to settle labor-management disputes concerning the
negotiation of a collective-bargaining contract. The mediator attempts to maintain
constructive discussions, to search for common areas of agreement and to suggest
compromises. However, the mediator's decisions are not binding, and they need not
be accepted by the contesting parties. The federal government provides mediation
services through an independent agency called the Federal Mediation and
Conciliation Service. In addition, most states and some large municipalities provide
similar services.
Economic Impacts of Unions
The growth of unions is not as significant as it once was. Nevertheless, unions exert
certain economic impacts on the economy. What are they?. On the basis of
numerous studies that have been done over the years, the main findings can be
summarized in the answers to three fundamental questions:
Do Unions Raise Wages?

Here we have to distinguish between unionized firms operating in the union labor
market and non-unionized firms operating in the nonunion labor market. Studies
have concluded that:
1. Unions increase total compensation (including wages and fringe benefits) in the
union market and decrease it in the nonunion market. This is because higher labor
costs in the union market prompts firms to reduce employment. Some of the
unemployed find it necessary to seek jobs in the nonunion market. This causes the
supply curve of labor in that market to shift to the right, leading to lower
compensation. The result is a. significant income differential between union and
nonunion workers. How large is the differential? The numbers differ widely
across industries, occupations, and individuals. However, as an overall average, it
appears that union workers earn roughly 20 percent more in total compensation
90
than nonunion workers.
2. The differential between union and nonunion wages tends to decline during
prosperity periods and increase during recessionary periods. The reason for this
is that union wages are relatively fixed in collective bargaining agreements
while nonunion wages can fluctuate with economic conditions. Hence, nonunion
wages usually rise faster than union wages during business-cycle upswings and
decline faster during cyclical downswings.
Do Unions Reduce Business Efficiency?
The answer to this question is not a simple yes or no. Let us look at three aspects
of the matter.
Impaired Worker Productivity As you have learned, some unions have long
utilized restrictive policies designed to limit output per worker. These practices
have reduced business efficiency.
Enhanced Worker Productivity Although some union practices have held down
output per worker, others have increased it. Unions have played an important
role in bringing about a safer working environment. They have also greatly
reduced the ability of management to discharge employees without "just
cause." Such achievements help to explain why union workers have lower quit
rates than nonunion workers. These factors have contributed to enhancing
productive efficiency in unionized firms.
Improved Plant Management Executives have often countered the negative

effects of union behavior by developing more efficient production methods.
Indeed, many important advances in production efficiency at the plant level
have been due in no small part to efforts aimed at overcoming inefficiencies
resulting from some union practices. Thus, unions have had both negative and
positive influences on business efficiency. There is considerable evidence that, on
balance, the positive effects have greatly outweighed the negative ones. As a
result, most unionized companies have higher productivity than comparable
nonunionized ones.
Do Unions Cause Inflation?
The answer to this question is not known. There are two schools of thought:
Monopolistic Markets View Many economists believe that much of the economy's
markets are not very competitive. Monopolistic labor unions are sometimes able,
therefore, to negotiate wage increases in excess of productivity gains. Monopolistic
firms, in turn, may agree to union demands if it is believed that wage increases can be
simply passed on to consumers in the form of higher prices. The phenomenon thus
results in a condition often referred to as cost-push inflation.
91
Competitive Markets View Another substantial group of economists believes that the
economy's markets are essentially competitive. Therefore, inflation is not caused by
unions, but by government policies. The most important policy consists of erratic
increases in the money supply caused by the nation's central bank—the Federal
Reserve System. In its efforts to stimulate employment and production the Fed often
"pumps" excessive quantities of money into the economy. This practice creates
demand-pull inflation—a condition sometimes described as "too much money
chasing too few goods."
Both of these points of view contain substantial elements of truth. Summarizing:
The effects of unions on the economy can be analyzed in terms of their impacts on
wages, business efficiency, and inflation. Various studies indicate the following:
Unions Raise Workers' Income Total compensation (including wages and fringe
benefits) of union workers is approximately 20 percent higher than for nonunion
workers.
Unions Have Had a Net Favorable Effect on Business Efficiency Certain union
practices have impaired worker productivity while others have enhanced it. However,
the evidence shows that the net influence of unions on productivity has been positive.
Unions Do Not Necessarily Cause I much disagreement over the extent to which
inflation results from unions pushing up wages. Many critics believe that inflation is
due to the Federal Reserve creating "too much" money.
Unions influence over wages

A labour union does not try to maximize wages because then only a few workers
would be hired. It also does not encourage firms to hire as many workers as possible,
because the wage rate would then be very low or zero. Instead, a general objective of
a labour union may be to increase the wage of union members.
Wages are determined by forces of supply and demand. Thus, for a union to modify
wages, it must in some ways modify or change the market for labour. There are three
general methods by which this can be done.
1. Increase the demand for labour

This will result in many workers being hired at an increased wage. This is the
most difficult because in general unions have little influence over the demand for
final products.
Unions support laws for protective tariffs or quotas on imports and have lobbed
against free trade agreement.
92
Increasing the productivity of labour will also increase the demand for labour.
Unions promote improved working conditions, shortened work weeks, and
employee education.
2. Reduce the supply of labour.

Unions are more successful with this method. Skilled unions can control supply
by controlling entry into the trading or requiring that the employees have a
certificate or license bearing witness of successful completion of the program.
Power to license is generally in the hands of the union, giving them power to
resrict labour supply. Reducing the supply of labour shifts the supply curve to the
left, increasing wages and reducing the number of worker’s employed.
3. Bargaining for higher wages

This method is generally utilized by unskilled or semi-skilled workers. The goal is
to bring all workers in the industry into union membership. Semi and unskilled
unions are unable to restrict the supply of worker’s by licensing. They established
closed shop, where all the workers in the firm or even the industry must belong to
the union. The union then represents all the worker’s and negotiates with the
management. It is important for union to require that all worker’s join the union,
otherwise the worker could be interloper- not join, save any union dues and still
reap any benefits from union regulations.
SUMMARY
Unions have employed different methods for enhancing their position in the labor
market. The methods include:
a. Increasing the demand for labor. This raises both wages and employment.
b. Decreasing the supply of labor. This raises wages and decreases
employment.
Activity
93
Explain how trade union influence wages and employment in the labour
market
Further Reading
Limited.
Irwin.
94
Lesson Ten
UNEMPOYMENT AND UNDER-EMPLOYMENT
Introduction
Unemployment is where people who are educated and willing to work cannot find
job. Workers are unemployed for many reasons. At any time for example, many
persons are in between jobs. They have either just quit or been laid off, or they have
just entered the labour market. It takes time to learn about and locate available job
opportunities.
Objectives

1 Explain the various types of unemployment
2 Define the asking wage
3 Explain how asing wage is determined
Types of Unemployment
The labour market is in constant influx. Some workers quit their jobs, other workers
are laid off. Some firms are cutting back, others are expanding. New workers enter the
market after completing their education and other workers re-enter after spending
some time in the non-market sector. At any time therefore, many workers are in
between jobs. If workers looking for jobs and firms looking for workers could find
each other immediately, there would be no unemployment. Frictional unemployment
arises because both workers and firms need time to locate each other and to digest the
information about the value of the job match.
Policy: providing worker with information about job openings and providing firms
with information about unemployed workers.
Seasonal unemployment
Workers in both the garment and the auto industries are laid off regularly because new
95
models are introduced.
Structural unemployment
It arises where persons looking for work cannot fit the jobs available. At any time,
some sectors of the economy are growing and other sectors are declining. If skills
were perfectly transferable across sectors, the laid off-workers could quickly move to
the growing sectors. Skills, however might be specific to the workers job or industry,
and laid-off workers lack qualifications needed in the expanding sector. As a result,
the unemployment spells of the displaced workers might last for a long time because
they must retool their skills. Structural unemployment thus arises because of a
mismatch between the skills that firms are demanding.
The problem is skills; the unemployed are stuck with human capital that is no longer
useful. Policy to reduce this type of unemployment is that the government would have
to provide training programs that would infect the displaced workers with the types of
skills that are now in demand.
Cyclical Unemployment.
There may be an imbalance between the number of workers looking for jobs and the
number of jobs available even if skills were perfectly portable across sectors. This
imbalance may arise because e.g. the economy has moved into a recession. Firms now
require a smaller workforce to satisfy the smaller consumer demand and employers
lay off many workers generating cyclical unemployment. There is an excess supply of
workers and the market does not clear because the wage is sticky and can not adjust
downward. The union-mandated wage increases or government-imposed minimum
wages introduce rigid wages into the labour market and prevent the market from
clearing.
To reduce this type of unemployment, the government will have to stimulate

aggregate demand and re-establish market equilibrium at the sticky wage.
Job search
Many theories claim to explain why unemployment exists and persists in competitive
market. We would observe frictional unemployment even if there were no
fundamental imbalance between the supply and demand for workers. Because
different firms offer different job opportunities and because workers are unaware of
where the best jobs are located, it takes time to find the available opportunities.
Any given worker can choose from among many different job offers, and different
firms make different offers to the same worker. These wage differentials for the same
type of work encourage unemployed worker to shop around until he/she finds a
superior job offer. Because it takes time to learn about the opportunities provided by
different employers, such activities pro-long the duration of the unemployment spell.
The worker, however, is willing to endure a longer unemployment spell because it
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might lead to a higher paying job. In effect, such unemployment is a form of human
capital investment; the worker is investing in information about the labour market.
The wage offer distribution

To simplify the analysis, we assume that only unemployed workers conduct such
activities, although workers might keep on searching for a better job even after they
accept a particular job offer. The wage offer distribution gives the frequency
distribution describing the various offers available to a particular unemployed worker
in the labour market.
Figure 10.0
Frequency
$5 $8 $22 $25 Wage
As drawn, the worker can end up in a job paying anywhere from $5 to $25 per hour.
Assume that unemployed worker knows the shape of the wage offer distribution. In
other words, he knows that there is a high probability that his search activities will
locate a job paying between $8 and $22 per hour and that there is a small probability
that he might end up with a job paying less than $8 or more than $22 per hour.
If search activities were free, the worker would keep on knocking from door to door
until he finally hit the firm that paid the $25 wage. Search activities, however, are
costly. He could have been working at a lower-paying job. The workers economic
trade-of is that the longer he searches, the more likely he will get a high wage offer,
the longer he searches, however the more it costs to find that job.
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Non-sequential and sequential search
When should the worker stop searching and settle for the job offer at hand?
There are two approaches to answering this question. Each approach gives a stopping
rule telling the worker when to end his search activity. The worker could follow a
strategy of non-sequential search where the worker decides before he begins his
search that he will randomly visit say twenty firms in the labour market and accept the
job that pays the highest wage (which will not necessarily be the job paying $25).
This search strategy is not optimal. Suppose that on his first try, the worker just
happens to hit the firm that pays $25. A non-sequential search strategy would force
this worker to visit another 19 firms knowing very well that he could never do better.
It does not make sense, therefore, for the worker to commit himself to a
predetermined number of searches regardless of what happens while he is searching.
Sequential search is where before the worker sets out on the search process, he
decides which job offers he is willing to accept. E.g. he might decide that he is not
willing to work for less than $12. If the wage offer exceeds $12, he will accept the
job, stop searching and end the unemployment spell. If the wage offer is less than $12,
he will reject the job offer and start the search process over again. i.e. visit a new firm,
compare the new wage offer to his designed wage and so on. The sequential search
strategy implies that if a worker is lucky enough and find the $25 job on the first try,
he will immediately recognize that he is lucky and stop the search process.
The asking wage
The asking wage is the threshold wage that determines if the unemployed worker
accepts or rejects the incoming job offers. There is a clear link between a worker’s
asking wage and the length of unemployment spells the worker will experience.
Workers who have low asking wage will find acceptable jobs very quickly and the
unemployment spell will be short. Workers with high asking wage will take a longer
time to find an acceptable job and the unemployment spell will be very long.
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The unemployment spell will last longer; the larger is the asking wage.
How worker determines his asking wage.

Consider the wage offer distribution given above. Suppose unemployed worker goes
out and samples a particular job at random. By pure chance, he happens to visit the
firm that pays the lowest wage possible $5. He must decide whether to accept or reject
this offer by comparing the expected gains from additional search.(by how much
would the wage offer increase?) with the cost of the search. If the offer at hand is $5,
the gains to searching one more time are very high. If the next visit gives him $10, the
incentive to continue searching will again depend partly on the marginal gain from
one more search. Given the wage offer distribution, there is still a good chance-that
additional search will generate a higher wage offer. The marginal gain to this
additional search however is not as high as when the wage offer was only $5. After all
there is a chance that if he searches one more time, he might hit a firm offering less
than $10.
Suppose the worker decides to try his luck one more time, this time he hits the
jackpot, getting a wage offer of $25. At this point, the marginal gain from further
search is zero. The worker cannot get a higher wage offer.
The marginal gains from search are lower if the worker has a good wage offer at
hand. As a result, the marginal revenue curve (ie marginal gain from one additional
search) is downward sloping.
The asking wage is also determined by the marginal cost of searching. There are two
types of search cost
(a) Direct costs of search, including transportation costs and costs of preparing
resumes and time taken
(b) Opportunity cost of rejecting the offer given. The marginal cost of search is
high if the worker has a good wage offer at hand. Therefore the MC is
upward sloping. The interaction of the MC curve and the MR gives the asking
wage or W
MC
MR
Hours
Consider what happens if the worker gets a wage offer of only $10 which is less than
the asking wage W. The MR from search exceeds the MC, and the worker would
99
continue searching. If the wage offer at hand was $20 (above the asking wage), the
worker should accept the job because the expected benefits from additional search are
lower than the MC of search. The asking wage therefore makes the worker indifferent
between continuing and ending his search activities
Determinants of the Asking wage

Workers asking wage will respond to changes in the benefits and costs of search
activities. The benefits from search are collected in the future, so they depend on the
workers discount rates. Workers with high discount rates are present oriented are
hence perceive the future benefits from search to be low.
Figure 10.2
Workers who have high discount rates have lower MR curves (Shifting the MR curve
from MR0 to MR1) and hence will have lower asking wages (W0 to W1) Because
these workers do not have the patience to wait until a better offer comes along, they
accept lower wage offers and have short unemployment spells.
The unemployment insurance (UI) system which compensates workers who are
unemployed and who are actively engaging in search activities also determines asking
wage. Suppose that the worker has a wage offer at hand of $ 400 and qualifies for UI
of $ 200, the worker is only given up to $ 200 by rejecting the job offer. The UI
benefits therefore reduce the MC of search.
Figure 10.3
100
A reduction in the MC of search (From MC0 to MC1) raises the asking wage from
W0 to W1. The UI system, therefore has three important effects on the labour market
1 It leads to longer unemployment spells
2 It increases the unemployment rate
3 It leads to higher post unemployment wages
In summary the search model has two key predictions about the length of
unemployment spell: Unemployment spells will last longer when the cost of searching
falls: and unemployment spells will last longer when the benefits from searching rise.
Although the asking wage is not observed directly, a number of surveys have
attempted to determine a workers asking wage by asking questions as what type of
work are you looking for? And at what wage would you be willing to take this job?
Summary
 There are various types of unemployment that can be found in an economy

 Asking wage is the wage where the marginal cost of job search is equal to the
marginal benefit of job search
Activity
Distinguish between structural and frictional unemployment
Further Reading
101
Limited.
Irwin.
102
Lesson Eleven
Labour Mobility
Introduction
Workers are always in motion. They move from one job to onother, or from one
geographical region to another or from one employer to another
Objectives
By the end of this lesson the learner should be able to:
1 Define the term labour mobility
2 Explain the various forms of labour mobility
3 Explain the determinants of labour mobility
Meaning
It means "the capacity and ability of labour to move from one place to another or from
one occupation to another or from one job to another or from one industry to another."
It is the extent to which the workers are able or willing to move between different
jobs, occupations, and geographical areas. It is called horizontal mobility if it does not
result in a change in the worker's grading or status, and vertical mobility if it does.
Skilled workers have low occupational mobility but high geographical mobility; low-
skilled or unskilled workers have high degrees of both types of mobility. Low labor-
mobility causes structural unemployment, and governments try to avoid it by worker
retraining schemes and by encouraging establishment of new industries in the affected
areas.
103
Types of mobility of labour
Mobility of labour is of following types.
1. Geographical Mobility - When a labourer moves from one region to another,

within the boundaries of a nation or from one nation to another is called
geographical mobility of labour.
2. Occupational Mobility - Movement of labourers from one job to another is

occupational mobility. This is in addition classified into Horizontal and
vertical nobilities. Horizontal mobility means movement in occupation by a
labourer from one grade to the different job in the same grade. Whereas
vertical mobility denotes, up gradation of jobs and status from lower to higher
from one occupation to another is called vertical mobility.
3. Mobility amidst industries - Movement of labourers from one industry to

another without changing the occupation is known as industrial mobility.
Factors Determining mobility of labour
1. Education and Training - The mobility of labour is based on the knowledge

and skill. The more of knowledge, the chance of movement amplifies.
2. Outlook or Urge - The outlook or urge of workers to rise in life determines

their mobility. If they are optimist and broad minded, they will move to other
jobs and places. Differences in language, habits, religion, and caste will not be
an obstacle in their mobility.
104
3. Social Set-up - The mobility of labour also depends upon the social setup. A
society dominated caste system and joint family system lacks in mobility of
labour. But in the cases where the convictions do not exist has mobility.
4. Means of Transport - Sophisticated modes of transport and communication

encourage mobility of labour. In case of emergency, communication with their
families or through aviation facilities one can meet out the situation.
5. Agricultural Development - At the times of vacation, in the event of

agricultural development, labour moves from high populated area to a lower
populace.
6. Peace and Security - The mobility of labour also based to a huge extent to the
law and order in the nation. In the event, if the properties of the populace are
not safe, they will not tend to move from their current place to another place
and to any corresponding occupation.
Obstacles of Mobility of Labour
There are several factors which encumber mobility of labour. They are changes in
weather, religious conviction, caste and creed, behaviour and mannerisms, traditions
and convictions, mother tongues, likings and choices etc. The other factors are
uneducated, lack of knowledge, indebtedness, affection to wealth and land,
deficiency, economic backwardness, lack of modes of transportation, communicating
skills and certainly redundancy.
Merits of Mobility of Labour
To augment productive efficiency, the mobility of labour helps a ton. Whist the
workers earning capacity also raises when they are prepared to shift from places to
better places. They get high paid jobs leaving low paid work. It resolves the
complexity of redundancy when the workers move from place to place. Also fiscal
development happens when unemployed shifts to public works like construction of
dams, building roads and canals etc. Thus it amplifies production, employment and
earnings.
105
Determinants of worker mobility
Workers move if the expected present value of the net benefits is positive
Benefits and costs of mobility

 Psychic costs and benefits are included as well as direct costs and benefits.
• costs and benefits include:
– friendships with co-workers and members of the community,
– family ties,
– working environment,
– non-pecuniary job benefits, and
– Characteristics of geographical locations.
Factors affecting the mobility decision
• Individuals are more likely to move when:
– the difference in wages or salaries is large,
– the worker is unhappy in his or her current job or location,
– the direct cost associated with moving is low, and
– Benefits will be realized over a longer time period (T).
Geographic mobility
• More strongly affected by the “pull” from the destination than by the “push”
from the original location.
• Young workers are more likely to move.
• Married workers are less likely to move.
• Most moves are within county and state boundaries.
• Chain migration is a common phenomenon in international migration.
Skills, income distribution, and migration

• when foreign countries have a lower degree of income inequality:
– the return to human capital is likely to be higher in the U.S.,
– Encouraging skilled individuals to emigrate to the U.S.
• When there is a higher degree of income inequality in foreign countries, low
skilled individuals are more likely to emigrate to the U.S.
• In recent decades, immigrants to the U.S. have been less skilled than in the
past.
Returns to migration
• Households generally receive an increase in income as a result of immigration.
• Wives often experience a decline in income as a result of immigration.
106
• Immigrants generally receive an initial income that is below that of domestic
workers.
• Immigrants experience a more rapid increase in earnings than for domestic
workers.
• Rate of growth of immigrant income has been lower in recent decades.
Return migration
• A substantial share of immigration involves return migration.
• this may be a planned return after a period of time working in a high-wage
area, or
• It may be the result of unrealized expectations.
Immigration and employment
• Immigration increases labor supply in some labor markets.
• Immigration raises labor demand in all labor markets.
• Domestic employment (and wages) will rise in those labor markets in which
labor demand rises by more than labor supply.
• Domestic employment (and wages) will fall in those labor markets in which
labor supply rises by more than labor demand.
Overall effects of immigration on economy
• Immigrant labor lowers the cost of goods, benefiting consumers.
• Immigrants pay more in taxes than they consume in public services (this is
especially true for illegal immigrants).
• Immigrants bring their human capital with them when they immigrate.
• Empirically, immigration appears to have little, if any, effect on the wage rates
or employment prospects of domestic workers.
Employee turnover and job matching
• employee turnover is the result of job quits and layoffs.
• workers will engage in a voluntary quit only if the expected benefits outweigh
the expected costs.
• Economic efficiency may improve as a result of job quits and layoffs.
Determinants of turnover
• Workers who receive a lower wage are more likely to quit.
• Firms that offer lower wages have higher quit rates.
• Women have higher quit rates.
• Job quits increase during expansions and fall during recessions.
• Layoffs rise during recessions and fall during expansions.
• Workers are less likely to quit when the cost of quitting is higher.
Worker mobility and monopsony
• When there are no costs of mobility, the law of one price would apply in labor
markets.
• Workers shift from job to job until the wage rate is the same everywhere for
workers with a given mix of skills and abilities.
• Mobility costs, however, give firms some degree of monopsony power in
labor markets.
107
Summary
 Labour mobility is the movement of labour across the labour marets

 There are variuous forms of labour mobility
 There are various factors that determine labour mobility in an economy
Activity
Explain the factors that determine the labour mobility
Further Reading
Limited.
Irwin.
108

EAE 304 - Labour Economics-1

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UNIT CODE: ECO 322

UNIT NAME: LABOUR ECONOMICS

An Economic Story of the labour Market

The actors in the labour market

An overview of Labour Economics

Unions and Collective

Macro-economic is concerned with the economic as a whole or with basic aggregates

 Labour economic studies how a labour markets work

State the policies examined by the modern labour economics

By the end of the lesson the learner should be able to:

Measuring the Labour Force

1 Labor, as defined in economics, means all personal services, including the

2 Labor Force This concept of labor supply is simply the employable

3 Labor-force Participation Rate This is the percentage of the total population

Labour force participation rate = LF/P

Labor-Force Participation by Women

Improved Marketability Changing social and cultural attitudes toward women

4 Employment-population ratio, sometimes called the employment rate, gives

Utility and indifference curves

The Budget Constraint

The Hours-of-Work Decision

An interior solution to the labour –

110 40 0 Hours of work

What happens to hours of work when non labour income changes?

The increase in V might be triggered by the payment of higher dividends on the

What happens to hours of work when the wage changes?

It seems therefore that, we cannot make an unambiguous prediction about wage

(a) Decomposition of the impact of a wage

To work or not work?

The Labour Supply Curve for a Worker

At the wages below the

Policy application: welfare programs and work incentives

The impact of the cash grant on work incentive is illustrated below.

70 110 Hrs of leisure

Marginal Product and Average Product

Figure 3.0: Graphs of Production Function

The employment decision in the short-run

The short-run labour demands curve for a firm.

Employment Decision in the Long-Run

Slope of iso-quant : δk = MPE

Higher iso- cost lines imply higher costs

Long-Run demand curve for labour

100 200 Output

Therefore the firm will jump to a higher isoquant as shown below.

Long-run demand curve

Substitution and scale effect

To conduct this decomposition, we introduce a new isocost line DD. DD is tangent to

1 Why is the short-run demand curve downward sloping?

This chapter analyses the properties of equilibrium in a perfectly competitive labour

By the end of the lesson the learner should be able to:

Wage determination in Competitive Labour Markets: Many Buyers, Many

Equilibrium in the competitive labour market requirement is that aggregate demand

(a) Institutional rigidities

Misperceptions about changes in wages and prices

Government may intervene in labour market through minimum wage regulation so

Wage Determination In a Monopsony Labour Market: One Buyer, Many Sellers

Cost Schedule of Labour Factor

Units of labour factor average cost of labour Total Marginal cost

Figure 4.3 MCF

Wage Determination In Monopoly Labour Market: One Seller, Many Buyers

Wage Determination In a Bilateral Monopoly Labour Market: One Buyer, One

In a bilateral monopoly, wages and employment may approximate competitive

Labour Market Imperfection