Revision for Test

Lecturer 5
• Long Run Labour Demand

What is the employment decision in the long run for a firm?

• In the long run, the firm maximizes profits by choosing how many workers to hire AND how much plant and equipment to invest in.

Define an isoquant.
– It describes the possible combinations of labor and capital that produce the same level of output.

Why is an isoquant downwardsloping?
• It means that in producing the same amount of output, a firm can substitute labor for capital and vice versa.

What is the characteristics of an isoquant map?
• Isoquants are convex to the origin, meaning diminishing MRTS. • An isoquant is downward sloping, meaning inputs are substitutable. • Two isoquants can never intersect. • Higher isoquants imply higher output.

Draw an isoquant for a firm.

What does an isocost line indicate?
• It indicates the possible combinations of labor and capital the firm can hire given a specified budget.

What do higher Isocost Lines indicate?
Capital C1 /r

They indicate more costly combinations of labor and capital.
Isocost with Cost Outlay C1

C0 /r

Isocost with Cost Outlay C0

C0 /w

C1 /w


Draw a diagram to illustrate a firm’s optimal combination of inputs in the long run.

C1 /r A C0 /r

P 175

B q0 100

A firm minimizes the costs of producing q0 units of output by using the capitallabor combination at point P, where the isoquant is tangent to the isocost. All other capital-labor combinations (such as those given by points A and B) lie on a higher isocost curve.

What does cost minimization imply? What is the condition for cost minization? • Cost minimization implies profit maximization. • The condition is where the isocost line is tangent to the isoquant, meaning the marginal rate of technical substitution equals the price ratio of capital to labor.

If wage rate drops in the long run long run, what are the two effectst that take place?

• If the wage rate drops, two effects take place
– scale effect
• Firm takes advantage of the lower price of labor by expanding production.

– substitution effect
• Firm takes advantage of the wage change by rearranging its mix of inputs (while holding output constant;)

What is the characteristics of the long run demand curve for labor?
Wage Rate



The long-run demand curve for labor gives the firm’s employment at a given wage and is downward sloping, i.e. more labor is demanded at at lower wage rate.




Chapter 6
Labor Market Equilibrium

What does the labor market coordinate?
• Labor market equilibrium coordinates the desires of firms and workers, determining the equilibrium wage rate and employment in the labor market

What are the conditions of a competitive labor market?
• • • • A large number of workers an employers Free entry and exit from the labour market Homogeneous labour services Perfect information

What is the meaning of economic efficiency in the labor market? • At equilibrium, both workers and employers are satisfied

• Hence economic efficiency is maximized

– Workers have maximized their satisfaction – Employers have maximized their profits

Draw a diagram to show the equilibrium in a competitive labor market.
Wage Rate ($)



D E*

The labor market is in equilibrium when supply equals demand; E* workers are employed at a wage of w*. In equilibrium, all persons who are looking for work at the going wage can find a job (i.e. there is no unemployment nor shortage of labour)

What is effect of CEPA on the labor markets in Hong Kong and China?
• CEPA created a free trade zone between Hong Kong and Mainland China • The effect of free trade in the zone is to make the labour market more competitive and hence reduce the wage differential within the zone • Total income of the countries in the trade zone is maximized as a result of equalized economic opportunities across the countries in the zone

Distinguish between “payroll taxes” and salaries taxes.
• Payroll taxes assessed on employers lead to a downward parallel shift in the labor demand curve
– The new demand curve shows a wedge between the amount the firm must pay to hire a worker and the amount that workers actually receive – Payroll taxes increase total costs of employment, so these taxes reduce employment in the economy – Firms and workers share the cost of payroll taxes, since the cost of hiring a worker rises at the same rate the wage received by workers declines

The Impact of a Payroll Tax Assessed on Firms


w1 + 1


w0 w1 w0 − 1 B


A payroll tax of $1 assessed on employers shifts down the demand curve (from D0 to D1). The payroll tax cuts the wage that workers receive from w0 to w1, and increases the cost of hiring a worker from w0 to w1 + 1.

D0 D1 E1 E0 D0 Employment


Salaries Tax in Hong Kong
• In Hong Kong personal income tax is known as salaries tax. Individuals are only assessed on annual employment income. Non-employment source income such as share dividends and capital gains realized on the sale of shares are not taxable in the territory. • Salaries Tax reduces the net gain of employees and therefore reduces the supply of labour

The Impact of a Salaries Tax Assessed on Employees
W S1



w1 + 1

D0 B A

w0 w1 w0 − 1

A salaries tax of $1 assessed on employees shifts up the supply curve (from S0 to S1). The salaries tax cuts the wage that workers receive from w0 to w1, and increases the cost of hiring a worker from w0 to w1 + 1.




D0 Employment

What are the two assumptions of the Cobweb model?
• Two assumptions of the cobweb model:
– Time is needed to produce skilled workers – Persons decide to become skilled workers by looking at conditions in the labor market at the time they enter school

In what kind of labor market is the Cobweb model applicable? • It is applicable in labor markets with high educational and/or training requirements.

Draw a diagram for the Cobweb model.

What is a monopsony in the labor market? Does a monopsonist have a labor demand curve? • Monopsony market exists when a firm is a lone buyer of labor (acting as a sole employer of labor in the market). • No. Such a firm has market power and can set wage rates to maximize his profit.

Draw a diagram to show the profit maximizing position of a monopsonist firm.
Remember a firm will hire workers up to the point where the marginal value of the last unit of the worker = the marginal cost to the firm
w, $ per worker

ie where the demand (for labour) curve = MWC curve
60 MWC , Marginal wage cost

Monopsonist values labour at $40, but it pays only $ 20

ME = 40 ec wc = 30 wm = 20 20 em

Supply If the market for labour were perfectly competitive and the firm faced a horizontal supply curve, than the equilibrium would be at ec (Demand for labour) VMP





L, Workers per day

Monopsonist hires fewer workers and pays a lower wage

Lecture 7
Human Capital

What is human capital? How is it similar to human capital? • It is the “quality of labour” • Similarity to “physical capital”
– productive – produced – It earns “returns” to the investment – It is subject to depreciation

In the “Human Capital Model”, how should a person decide on investing in education?

• The decision should be made by comparing the costs and benefits (higher earnings) of more education.

What are the costs of more education? • Costs of more education
– The direct costs are the cost of tuition, fees, and books.
• Room and board are not included since they are needed regardless of whether you go to school.

– The indirect cost is the forgone earnings you give up while you attending school.

Sketch the Age-Earnings profiles of a person with and without higher education
• • • HH curve: a person does not attend school. CC curve: one attends school. Total cost (attending school) = Direct costs (area 1) + Indirect costs (area 2). Total benefit (attending school)= Increase in earnings (area 3). Whether it is rational to attend school depends on whether the present value of the benefits exceeds the present value of the costs.
Incremental Earnings (3) H

Annual Earnings


• •

H Indirect

Costs (2) 22 65 Age

18 C

Direct Costs (1)

Taking a training program?

• Suppose Melinda is considering taking a a training program that involves direct costs of $3,000 and forgone earnings $5,000. The training program will increase Melinda’s earnings by $3,000, $4,000, and $5,000 for the 3 years she plans on working. • Because she can borrow the funds at an interest rate of 10%, we will discount the future expected income at an 10% rate. • What is the present value (PV) of this training program?

Taking a training program?
PV of $8,000 Investment in a training program
(Interest Rate = 10 Percent) Year (1) Incremental Earnings (2) Discounted Value (10 Percent Rate) (3) Present Value of Earnings (4)

0 1 2 3

-$ 8,000 $ 3,000 $ 4,000 $ 5,000

1.000 0.909 0.826 0.751

$ $ $ $

-8,000 2,727 3,305 3,755

$ 1,787

• The PV of the training program is positive, Melinda should take the training program.

What is the demand for human capital? How is it affected by the discount rates?
• The demand for human capital can be regarded as the years of schooling demanded at various discount rates. • The higher the discount rate, the less likely someone will invest in education (since they are less future oriented)

Draw the demand for human capital.


• The individuals should increase schooling so that the marginal rate of return of schooling is equal to the interest rate .

1 i1 i2 i3 2 3 D




Years of Schooling

How do ability differences affect the demand for human capital?
• Higher abilities implies higher demand because higher abilities will imply higher future stream of incomes.

A i





Years of Schooling

What does “Schooling as a signal” mean?
• It means that education reveals a level of attainment which signals a worker’s qualifications to potential employers. • This information (signal) is used to allocate workers in the labor market.

Why is there a “separating equilibrium” between low and high productivity workers?

• Both are satisfied at different wage rates
– Low-productivity workers choose not to obtain X years of education, voluntarily signaling their low productivity – High-productivity workers choose to get at least X years of schooling and separate themselves from the pack

What are the two types of on-the-job training? • Two types of OJT:
– General: training that is useful at all firms once it is acquired – Specific: training that is useful only at the firm where it is acquired

Under what will a firm invest on on-the-job training for its employees?
• Firms will invest in on-the-job training if the present value of the benefits of the training exceeds the present value of the costs. • The costs to the firm include: – Direct costs such as classroom instruction and greater worker supervision. – Indirect costs such as reduced worker output during training. • The benefit is greater worker productivity.

Draw a diagram to show the costs and benefits of “General Training” to a worker. Who should pay the cost of training?
• Wu and VMPu are the wages and value of marginal product for an untrained worker. Wage & Value of Marginal Product

• Since general training is usable at other firms, workers must pay for the entire cost of the training. They receive a lower wage (Wu> Wt) that is equal to their diminished productivity (VMPt). • After the training period, workers receive a higher wage Wp that is is equal to their new higher level of productivity VMPp.

Wp= VMPp

Wu= VMPu Wt= VMPt Post Training


Draw a diagram to show the costs and benefits of “Specific Training” to a worker. Who should pay the cost of training?
• Since specific training is not transferable to other firms, the employer must pay for the training. • During training, the employer pays a wage greater than the worker’s productivity (Wu> VMPt). • After training, the employer gets a return on her training investment by paying a wage less than the worker’s productivity (Wu < VMPt). • The employer may pay a higher wage to decrease worker turnover and thus protect her training investment (Wp’ ). Wage & Value of Marginal Product

VMPp Wp’ Wu= VMPu VMPt Post Training


Lecture 8: The Wage Structure

How can rewards to workers be classified? Explain. • Intrinsic Rewards
– They are those rewards that come from within an individual. They reflect satisfaction from doing the job, such as better status, more opportunities for growth or assuming greater responsibility.

• Extrinsic Rewards
– They are rewards that employers provide to workers to recognize a job well done. They can be nonfinancial (office, staff, title, etc.) or financial (direct and indirect compensation)

Why do wage differentials exist?
• Wage differentials exist due to Human capital investments that vary from worker to worker • Compensating wage differentials • Differing Skill Requirements • Other Job or Employer Heterogeneities • Non-Competing Groups • Difference time preferences of workers • Differences in non-wage amenities

Draw and explain the Lorenz Curve and the Gini Coefficient.

Perfect-equality Lorenz curve

Actual Lorenz curve



The “perfect-equality” Lorenz-curve is given by the line AB, indicating that each quintile of households gets 20 percent of aggregate income, while the Lorenz curve describing the actual income distribution lies below it. The ratio of the shaded area to the area in the triangle ABC gives the Gini coefficient.

What are the sources of compensating wage differentials?
• • • Risk of job injury or death • Riskier jobs pay higher wages Fringe benefits – Jobs with greater fringe benefits pay lower wages Job status – Jobs with greater prestige pay lower wagesJob location – Cities with greater amenities pay lower wages. – Cities with greater cost of living pay higher nominal wages. Job security – Jobs with greater job security pay lower wages. Prospect of wage advancement – Jobs with greater wage advancement have lower starting wages. Extent of control over the work place – Jobs with less personal control over the workplace and less flexible work hours pay higher wages.

• • •

Explain Four factors that may widen the wage gap. • Globalization of the economy • Demand for skilled workers increased by more than the demand increase for unskilled workers • Increased physical capital helped to increase the productivity of skilled workers • Weakened bargaining power of unions could be from the relative shift in demand for skilled labor

Lecture 9: Labour Mobility

What is labor mobility in Globalization? What will it improve?

• Any movement of workers across national boundaries constitutes labour mobility. • Labor mobility is the mechanism that labor markets use to improve the allocation of workers to firms.

Why do workers move to another place to work?
• They could have been persecuted for political or religious reasons, • They can aim to a more prestigious job or • They can search for a better quality of life having a better-paid job.

What is “Brain Drain”? How does it affect the workers’ home country?

• It is the phenomenon under which skilled workers leave their own country after having achieved their education, to work in a country where they have more attractive job prospects. This phenomenon is a loss for the home country economy.

How does the net present value of migration affect a worker decision to migrate? • Workers will migrate if the net present value of migration (Vp) is greater than zero.

What are the determinants of migration for workers?
• • • • Age – Older individuals are less likely to migrate. Family factors – The costs of migration rise with family size. Education – Migration is more likely as education levels rise. Distance – The probability of moving falls with the distance the person must move. Unemployment rates – Families headed by unemployed persons are more likely to move. – The unemployment rate at the origin location positively affects the probability of out-migration.

Under what condition will a family migrate? Will the decision on migration lead to tied stayers or movers?

• The family unit will move if the net gains to the family are positive • The optimal choice for a member of the family may not be optimal for the family unit (and vice versa)
– Tied stayer – one who sacrifices better income opportunities elsewhere because the partner is better off in their current location – Tied mover – one who moves with the partner even though the employment outlook is better at their current location

Draw a diagram to explain the conditions for tied movers and tied stayers.
Private Gains to Husband (∆PVH)






Private Gains to Wife (∆PVW)

-10,000 X

∆PVH + ∆PVW = 0

If the husband were single, he would migrate whenever ∆PVH > 0 (or areas A, B, and C). If the wife were single, she would migrate whenever ∆PVW > 0 (or areas C, D, and E). The family migrates when the sum of the private gains is positive (or areas B, C, and D). In area D, the husband would not move if he were single, but moves as part of the family, making him a tied mover. In area E, the wife would move if she were single, but does not move as part of the family, making her a tied stayer.

Who are the winners of labor mobility? • Migrants (and females back home)
– they are taking much more money and having comfortable life. So do their wife and relatives

• Home country workers.
– Wage level in home country is increasing due to a decrease the supply of labor at home.

• Host country employers
– Compared with before they are finding less expensive labor which reduces their production costs.

Who are losers of labor mobility?

• Home country employers
– Owing to migration to other countries, wage levels rise and employers have to pay more money which increases their production costs.

• Host country workers (similar skills)
– Immigration causes wage level of workers in the host country to decrease because of abundant labor supply.

Explain, with appropriate supply and demand diagrams, the migration of workers between low-wage China and high-wage Hong Kong.
• The migration of labour from low-wage Mainland China to highwage H.K. will increase the domestic output and reduce the average wage in the H.K and produce the opposite effects in Mainland China. The output gain of ebcf in H.K. exceeds the loss of kijl in Mainland China.
Wage rate


Wu We


Wage rate



c Du

We Wm

i m j


The value of combined outputs from the two nations rises. e



Quantity of Labor

k l
Mainland China

Quantity of Labor