Modern Labor Economics: Frictions in The Labor Market

MODERN LABOR ECONOMICS
THEORY AND PUBLIC POLICY 12TH EDITION
CHAPTER 5
Frictions in the Labor
Market
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Chapter Outline
Frictions on the Employee Side of the Market
• The Law of One Price
• Monopsonistic Labor Markets: A Definition
• Profit Maximization under Monopsonistic Conditions
• How Do Monopsonistic Firms Respond to Shifts in
the Supply Curve?
• Monopsonistic Conditions and the Employment
Response to Minimum Wage Legislation
• Job Search Costs and Other Labor Market
Conditions
• Monopsonistic Conditions and the Relevance of the
Competitive Model
Chapter Outline
Frictions on the Employer Side of the Market
• Categories of Quasi-Fixed Costs
• The Employment/Hours Trade-Off
Training Investments
• The Training Decision by Employers
• The Types of Training
• Training and Post-Training Wage Increases
• Employer Training Investments and Recessionary
Layoffs
Hiring Investments
• The Use of Credentials
• Internal Labor Markets
• How Can the Employer Recoup Its Hiring Investments?
5.1 Frictions on the Employee Side of the
Market
The Law of One Price (LOP)
Workers who are of equal skills within occupations will

receive the same wage – there will be no wage differentials.
• Assumptions underlying the LOP:

• Every employee has information about available
jobs – information is costless.
• Mobility or job search across employers is costless.
• Labor supply curve is horizontal.
Market
 Mobility or job search across employers is NOT costless.
• Job search takes time and effort.
• Costs of job search include:
(a) application – printing résumés and postage
(b) interview – buying expensive clothes for interview
and roundtrip fares
(c) travel – hiring movers if employed
(d) psychological costs – missing friends and family
members.
 Costs of job search/mobility make the supply curve to be
upward sloping and not horizontal as assumed earlier.
Figure 5.1 The Supply of Labor to Firm A: Worker-Mobility Costs Increase
the Slope of the Labor Supply Curve Facing Individual Employers
Higher mobility costs will

elicit low labor/employment
responses if wage changes.
Lower mobility costs

will elicit high
labor/employment
responses if wage
changes.
Market
Monopsonistic Labor Markets: A Definition
 A labor market monopsonist is the only buyer/employer
of labor in its labor market.
 The employer faces an upward labor supply curve but its
MEL (or MCL) is much higher than the wage rate.
Profit Maximization under Monopsonistic Conditions

 Recall that:
• profit-maximizing firms will hire as long as MRPL > MEL
• hiring stops when MRPL = MEL
• when firms face upward sloping supply curves, the MEL

exceeds the wage.
Market
Why the Marginal Expense of Labor Exceeds the Wage Rate
• The marginal expense of labor (MEL) exceeds the wage

rate because:
 potential employees find it costly to change jobs, so
the firm must be willing to pay higher wages to attract
workers from other employers,
 the MEL includes to the wages paid to the extra
worker plus the additional cost of raising the wage for
all other workers.
Table 5.1
Figure 5.2 A Graph of the Firm-Level Data in Table 5.1
Market
The Firm’s Choice of Wage and Employment Levels

• The monopsonist hires workers up to the point
where:
MRPL = MEL (5.1)
• The labor market effects caused by MEL > W :

 A labor market monopsonist hires less workers in
comparison to the competitive employer(s).
 A labor market monopsonist pays a wage that is less
than the competitive wage – exploits workers.
Figure 5.3 Profit-Maximizing Employment and Wage
Levels in a Firm Facing a Monopsonistic
Labor Market
Market
Monopsonistic Conditions and Firms’ Wage Policies
• The employers in monopsonistic labor markets must decide on the
wage to pay unlike in the perfectly competitive labor markets where
firms are wage takers.
• Firms must make labor market decisions that allow them to remain
competitive in their product markets.
• Product and labor market constraints may cause firms in
monopsonistic labor markets to offer different wages to equivalent
workers.
• Due to the unlikelihood that SL and MRPL curves would be exactly
the same for different firms in the same labor market, it should be no
surprise if exactly comparable workers have different marginal
productivities and receive different wages at different firms.
Market
How Do Monopsonistic Firms Respond to Shifts in the

Supply Curve?
 The labor market monopsonistic firm does not really have a labor
demand curve – it has MRPL curve.
 The monopsonistic firm is not a wage taker and its MRPL curve
shows various levels of employment of which there is only one
profit-maximizing level of employment and only one associated
wage rate.
Shifts in Labor Supply Curve That Increase MEL
•If fewer workers are willing to work and the labor supply shifts to the
left, the short-run effects are:
 employment level (E) will fall to E’ and the market wage (W) will increase to W’
 MEL will also shift to a higher level (ME’L).
Figure 5.4 The Monopsonistic Firm’s Short-Run Response to
a Leftward Shift in Labor Supply: Employment

Falls and Wage Increases
Market
In the long run, the monopsonistic firm’s cost minimizing mix of
capital (K) and labor (L) would require:
Similar to equations:
(3.7a) P. MPL = MEL (remember that MEL > W)
(3.7b) P.MPK = C
MEL
P
MPL(3.8a)
C (3.8b)
P
MPK
(3.8c) MEL C
  (5.2)
MPL MPK
Market
Effects of a Mandated Wage

•A mandated wage (Wm) prevents a firm from paying a wage
less than Wm – this creates a perfectly elastic labor supply
curve facing the firm, thus altering its MEL curve.
•A profit-maximizing firm will hire labor where the MRPL

insects the perfectly elastic labor supply curve (MEL curve)
created by Wm – see employment at Em in Figure 5.5.
•For a monopsonistic firm, Wm can simultaneously increase

the average cost of labor and reduce MEL – the decrease in
marginal expense will induce the firm to expand output and
employment in the short run.
Figure 5.5 Minimum-Wage Effects under Monopsonistic Conditions: Both Wages
and Employment Can Increase in the Short Run
BDS = Labor supply curve based on a mandated Wm

BDEM = Marginal expense of labor curve (MEL) based on Wm
MRPL = MEL (which is given as BDEM based on Wm) → Em
Market
Monopsonistic Conditions and the Employment

Response to Minimum Wage Legislation
 Legislated increases in Wmin raise wages.
 Modest increase in Wmin can reduce MEL.
 Fall in MEL may cause some firms/employers to

experience increases in employment.
 Higher total labor costs due to Wmin may force

some firms/employers to close.
Market
Job Search Costs and Other Labor Market

Outcomes
 Despite the job search costs, some workers’ high wage
levels may be due to luck – they are lucky to be employed
by a high-paying/high-productivity employer.
 Job mobility/search costs for workers may explain why:

• Wages increase or improve over time with workers’
labor market experience or activity.
• Wages increase with workers’ length of time (tenure)
with their particular employers.
Market
Wage Levels, Luck, and Search
• Employee mobility costs can create, other things equal,
monopsonistic conditions that result in pay differences among
workers who have equal productive capabilities.
• The implication is that to some extent, a worker’s wage depends on luck –
some workers will be lucky to obtain a job offer from high-paying employer.
• Workers who see their jobs as a poor match (due to low pay) have
more incentive to search for other offers than the lucky ones who
have good matches with high wages.
• Labor-market studies have observed that workers’ wages tend to
increase both with
(1) overall labor market experience, and
(2) holding labor market experience constant, the length of time with one’s
employer (“job tenure”).
Market
Wage and Labor Market Experience

• Workers who have spent more time in the labor market
have had more chances to acquire better offers and thus
improve upon their initial job matches – that is, workers’
wages improve the longer they are active in the labor market.
Wages and Job Tenure

• With costly job searches, workers who are fortunate
enough to find jobs with high-paying employers will have
little incentive to continue searching.
• Those who have longer job tenure with their employers also
tend to have higher wages.
Market
Job Search Costs and Unemployment
• Job search costs can help to explain the existence (and
level) of unemployment – the longer it takes for a worker
to receive an acceptable offer, the longer the unemployed
worker will remain unemployed.
Monopsonistic Conditions and the Relevance of
the Competitive Model
 The competitive model may offer predictions that are at
least partially contradicted by evidence but it does not
mean that it is irrelevant, especially in the long run.
 The major difference between the competitive and
monopsonistic models is the assumption about employee
mobility costs.
5.2 Frictions on the Employer Side of
the Market
Categories of Quasi-Fixed Costs
The frictions on the employer side of the market cause firms
to bear “quasi-fixed costs” that are difficult to cut in the short
run.
Quasi-fixed costs fall into two categories: investments in
their workforce and certain employee benefits.
Labor Investments
(1)Costs of hiring replacements such as advertising the
position, screening, interviewing, “wine and dine”,
and
terminating – severance pay, and
(2) Costs of formal or informal training – firms incur
explicit
Modern Labor Economics: Theory and Public Policy, Twelfth Edition
Ronald G. Ehrenberg • Robert S. Smith
Copyright ©2015 by Pearson Education, Inc.
All rights reserved.
Table 5.2 The Marginal Product of Labor in a Hypothetical
Car Dealership (Capital Held Constant)
5.2 Frictions on the Employer Side of the
Market
Employee Benefits
• Workers also receive other fringe benefits in
addition to their wage and salary earnings.
These other benefits fall under the following
categories:
(1) legally required payments such as social security,
workers’ compensation, and unemployment insurance
(2) retirement – defined benefit plans depend on years of
service years, and defined contribution plans
(3) Insurance – medical and life
(4) Paid vacations, holidays, and sick leave
(5) Others
See Table 5.3, p.149 for these categories.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition
Ronald G. Ehrenberg • Robert S. Smith
Copyright ©2015 by Pearson Education, Inc.
All rights reserved.
Table 5.3
Market
The Employment/Hours Trade-Off
 The fact that certain labor costs (quasi-fixed costs) are not hours-
related, while others are, will lead employers to think of “workers”
and “hours-per-worker” as two substitutable inputs in the production
process, therefore, L is divided into:
(a) Number of “workers” hired – denoted as M
(b) “Hours-per-worker” on the average – denoted as H.
Then, let:
MPM = ∆Q/∆M|K and H constant → added output associated with
each added worker.
MPH = ∆Q/∆H|K and M constant → added output generated by
increasing average hours per
worker.
Market
Determining the Mix of Workers and Hours

Using the profit-maximizing level of employment:
P.MPM  MEM
P.MPH  MEH
MEM
P
MPM
MEH
P
MPH
MEM MEH MEM MPM
  or  (5.3)
MPM MPH MEH MPH
Figure 5.6 The Predicted Relationship between MEM /MEH
and Overtime Hours
If MEM > MEH : This will lead to ↑ H and ↓ M because
of the quasi-fixed costs incurred in hiring more M.
Conversely, if MEM < MEH : This will lead to ↑ M (use
more contingency workers with no benefits) and ↓ H.
Market
Policy Analysis: The Overtime Pay Premium

• The Fair Labor Standards Act requires that employees
covered by the act (hourly paid, nonsupervisory workers)
receive an overtime pay premium of at least 50 percent of
their regular hourly wages for each hour worked in excess of
40 hours per week.
• Employers who regularly schedule overtime do so because it
is cheaper than incurring the quasi-fixed costs of employing
more workers.
• In fall 2004, the U.S. Department of Labor introduced several
controversial revisions to federal overtime regulations that
redefined which jobs are exempt from coverage.
Market
Overtime and Spreading the Work

• The time-and-one-half requirement for overtime
protects workers by “spreading the work” (creating more
job openings) through reduced usage of overtime.
• If firms eliminate overtime and hire more workers at the
same base wage rate, their labor costs will clearly rise,
thus reducing the scale of output and increasing firms’
incentive to substitute K for L.
• Even if base wages are not changed, it is unlikely that
all the reduced overtime hours will be replaced by hiring
more workers.
Market
Overtime and Total Pay

• Many overtime hours are regularly scheduled with the
possible mutual agreement between the employees and
employers on a “package” of weekly hours and total
compensation.
• Employers could respond to a legislated increase in coverage
by reducing the straight-time salary such that with the new
overtime payments considered, total compensation per
worker remained unchanged.
• A study of the effects of overtime premiums in the U.S. found
evidence that base wages adjust to mandated changes and
that the legislated expansions in overtime coverage have had
no measurable effect on overtime hours worked.
5.3 Training Investments
 Recall that employer-provided training is part of the
quasi-fixed costs of hiring workers.
The Training Decision by Employers

 Employers incur explicit and implicit training costs if the
decision is to train a worker after hiring.
 During training, Coststraining > MRPL, therefore, training will

be undertaken if the employer believes it can collect returns
after training:
(1) increased worker productivity (↑MRPL more than W),
(2) reduced turn-over – employee stays longer with the firm.
The Types of Training
 At the extreme, there are two types of training that
employers can provide: general training and specific
training.
General Training – Teaches workers skills that can be used
to enhance their productivity with many employers – skills
are easily transferable – thus paying for general training can
be a risky investment for an employer.
Specific Training – Teaches workers skills that increase
their productivity only with the employer providing the
training – skills are firm-specific and not transferable – thus
employers have stronger incentives to invest in specific
training.
Training and Post-Training Wage Increases
 The best way to provide incentives for on-the-job (OJT) is for
employees and employers to share the costs and returns of
the investment in training.
 If employees bear part of the training costs, post-training
wage can be increased more than if employers bear all the
training costs.
 Employers can recoup training costs by not raising the
post-training wage too much – a point confirmed by
empirical evidence – see Figure 5.7, p. 157.
 Increased post-training wage may protect employers’
investment by reducing the chances that the trained
workers will quit.
Figure 5.7 Productivity and Wage Growth, First Two Years
on Job, by Occupation and Initial Hours of Employer Training
Employer Training Investments and Recessionary
Layoffs
 Employers will invest in OJT of its workers as long as:
MRPL|after training > W |after training.
 If due to a recession, MRPL|after training is barely greater than
W |after training, the employer will not layoff its trained
employees, particularly, those workers with specific
training and the longest job tenure.
 Employers cannot recoup training costs from laid-off
workers/employees who obtained specific training.
 If MRPL|after training < W |after training and a recession is
prolonged, employers may have no choice but to layoff
workers because it is profitable to do so.
5.4 Hiring Investments
 Firms bear the hiring and training costs of workers, thus, it is
in their interests to reduce costs through effective evaluations
when making hiring-placement-promotion decisions.
The Use of Credentials
 Firms rely on credentials or signals to determine workers’
trainability (fast learners vs. slow learners) and potential MPL.
(a) Are college graduates (CG) more productive than high
school graduates (HSG)?
(b) If yes, there is no need to waste valuable resources in
interviewing and testing all candidates (CG and HSG) to
find out their respective MPLs.
 Firms use educational standard to screen applicants and
such use of credentials to judge group characteristics can
lead to statistical discrimination – with obvious costs.
Internal Labor Markets
 Internal labor markets(ILM) exist or firms create them
because they cannot ascertain workers’ personal attributes
(dependability, motivation, honesty, and flexibility) based on
interviews, employment tests, or even recommendations of
former employers.
 Firms fill job vacancies with employees from within (ILM)
because they know more about their current employees
than those from outside – firms can make better decisions.
 Hiring within the ILM may not be economically efficient and
cost effective, but it fosters workers’ attachment to the firms.
 Firms that invest heavily in specific training use ILM.
How Can the Employer Recoup Its Hiring
Investments?
 Firms/Employers can recoup their hiring investments by
hiring only those employees whose productivity would be
higher than the average productivity.
 Firms can recoup their hiring investments by paying a
wage that is higher than the average wage but still less
than the workers’ marginal productivity:
MRPL| after training > W > Waverage
 Paying W > Waverage, high mobility costs, and the fact
information obtained about a worker by a particular
employer may not be relevant across employers, the
employee is more likely to remain longer with its employer.

Modern Labor Economics: Frictions in The Labor Market

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Modern Labor Economics: Frictions in The Labor Market

Uploaded by

Copyright:

Available Formats

MODERN LABOR ECONOMICS

THEORY AND PUBLIC POLICY 12TH EDITION

The Law of One Price (LOP)

Workers who are of equal skills within occupations will

• Assumptions underlying the LOP:

Higher mobility costs will

Lower mobility costs

Profit Maximization under Monopsonistic Conditions

• when firms face upward sloping supply curves, the MEL

Why the Marginal Expense of Labor Exceeds the Wage Rate

• The marginal expense of labor (MEL) exceeds the wage

The Firm’s Choice of Wage and Employment Levels

• The labor market effects caused by MEL > W :

How Do Monopsonistic Firms Respond to Shifts in the

a Leftward Shift in Labor Supply: Employment

Effects of a Mandated Wage

•A profit-maximizing firm will hire labor where the MRPL

•For a monopsonistic firm, Wm can simultaneously increase

BDS = Labor supply curve based on a mandated Wm

Monopsonistic Conditions and the Employment

 Modest increase in Wmin can reduce MEL.

 Fall in MEL may cause some firms/employers to

 Higher total labor costs due to Wmin may force

Job Search Costs and Other Labor Market

 Job mobility/search costs for workers may explain why:

Wage and Labor Market Experience

Wages and Job Tenure

Determining the Mix of Workers and Hours

Policy Analysis: The Overtime Pay Premium

Overtime and Spreading the Work

Overtime and Total Pay

The Training Decision by Employers

 During training, Coststraining > MRPL, therefore, training will

You might also like