Lecture 21: Labor markets

Outline
1. Productivity review
2. Labor demand
3. Labor supply
4. Market power in labor markets

Required Reading
• Chapter 19
• Chapter 19 appendix

Econ 101: Principles of Micro 1

Productivity review
• We have spent much of our time talking about allocation
• Surplus, willingness-to-pay, monopoly rents

• Let’s wrap up the class by talking about a closely related concept: the
distribution of income and wealth.

• First (today), we must study the economist’s baseline model of income

determination
• We can then turn to the theory and measurement of distribution
• Finally, talk about intervention: what does, can, and should the
government do about income inequality?

Econ 101: Principles of Micro 2

Productivity review
• We have studied labor already this semester – in Chapter 11, costs
•  Remember the production function: the Total Quantity Marg prod
quantity of output generated by different workers (L) of output of labor
amounts of labor, holding other inputs 0 0 -
constant 1 50 50
• From the production function, we can get 2 92 42
the marginal product of labor (MPL) 3 126
34
4 152
• MPL = 26
5 170
18
6 180
10
7 182
2

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Productivity review
Q Q

TP

MPL
L L
Total product of Labor Marginal product of Labor
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Productivity review
• Given fixed costs, we assume that total product is marginally decreasing
• TP rises at a falling rate

• Generally, therefore, we think MPL is positive but downward-sloping.

• The vertical axes on the last slide were “Q”

• From there, we generated the total cost (of producing Q)
• We developed cost curves to build the supply curve of the good
produced

• Today, we’re not talking about the market for the output, we’re talking
about the market for the input, labor.
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Productivity review
• We will model the supply and demand
OF LABOR

• Like with the minimum wage, need to

flip the usual perspective
• Remember circular flow
• Demanders: firms. Hire workers in
order to produce goods
• Suppliers: households. Provide labor services in order to earn income
(which allows them to buy goods and services)

Econ 101: Principles of Micro 6

Labor demand
• Firms hire workers to produce a good, which the firm then sells
• The money the firm makes on these sales is the benefit of hiring a
worker

• The worker will only put in the effort of producing that good if they are
paid
• That pay, the worker’s wage, is the cost of hiring a worker.
• Suppose the labor market is competitive. Then the firm is a price-taker
in the labor market. The marginal cost of another worker is the wage.

• A profit-maximizing firm hires more workers as long as the marginal

benefit of an extra worker is at least as big as their marginal cost.
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Labor demand
• Suppose this is a candy bar market.
Each candy bar produced can be sold
(in a competitive market) for P = $0.50 VMPL =
L MPL P*MPL
• If a worker produces 10 candy bars
0 - -
in an hour, that allows the firm to
1 50 $25
generate revenue of 10*$0.50 =
2 42
$5.00. $21
3 34
$17
• We say the Value of the Marginal 4 26
$13
Product of Labor (VMPL) equals 5 18
$9
the marginal product of a laborer, 6 10
$5
times the price of that product 7 2
$1
• VMPL = P * MPL
Econ 101: Principles of Micro 8
Labor demand
$
• The wage is the marginal cost of labor
Hourly profit to hiring
• Suppose in this market the the 2nd worker = $8
competitive w = $13
$21
• Optimal (profit-maximizing) hiring
occurs at the quantity of workers
where w = VMPL $13 w
• Every worker up to that point
increases the firm’s profit.
VMPL
• “At a price of labor of $13, the
2 L* = 4 L
quantity demanded of labor is 4”
Candy factory firm
Econ 101: Principles of Micro 9
Labor demand
$
• What’s equilibrium L when w = $9?

• Just look back at our VMPL schedule

• “At a price of labor of $9, the
quantity demanded of labor is 5”

• Given a competitive labor market

(and output market), the firm labor
$9 w
demand curve is identical to that
firm’s VMPL curve VMPL

L* = 5 L
Candy factory firm
Econ 101: Principles of Micro 10
Quiz
• Firm labor demand is P*MPL = VMPL
• Which of the following would NOT shift the firm labor
demand curve?
A. The wage paid to workers rises
B. The good being produced falls in price
C. A new technology allows a worker to make more
goods in an hour
D. The firm buys more tools for its workers to use
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Quiz
• Shifters of firm labor demand (LD = VMPL = P*MPL):

1. A change in price makes the good produced more or less valuable

• Therefore, the benefits of hiring a worker increase or decrease

2. A better technology makes workers more productive.

• Produce more stuff in an hour  more stuff for the firm to sell  more
revenue  (given wage) more profit!

3. When a firm adjusts its use of other inputs, productivity will change
• More tools (capital) means more productivity. Same with land, etc

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Labor demand
• As always, add up all firm’s demands (given wage) to get market demand
• For now, I’ll add that this is “demand for a certain type of worker”
• Talk more about this in the next class
• Different workers have different skills, knowledge, traits, job
characteristics, and so on.
• Hold all those things constant
• For example, we are modeling “Candy (food) factory labor” now

• Equilibrium wage comes from the intersection of market demand and

market supply. Now we need supply!

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Labor supply
• Suppliers are individuals
• Individuals are utility maximizers
• The labor supply choice involves budget constraints and indifference
curves.

• Suppose there are two types of goods: market goods and non-market goods.
• Market goods are the kind you buy with your income – the kind we’ve
been discussing throughout the class
• Non-market goods are more simply called leisure: things you enjoy on
your “free time”
• Relaxing, talking with friends, visiting the park with your kids, etc.

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Labor supply
• Leisure is a good that you value, just like market goods.

• Suppose you work for an hour

• What’s the benefit?
• You are paid a wage. You have greater ability to buy market goods.
• What’s the cost?
• You have an hour less of leisure - a good you’ve given up in order to
work. An opportunity cost.

• So, the labor supply choice is a tradeoff: get more of one kind of good in
exchange for less of another. How much do you value each, at the margin?

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Labor supply
• Two more assumptions:
1. You must sleep/rest for 8 hours a day, and you don’t work weekends.
• Have 16 hours/day, 5 days/week = 16*5 = 80 hrs/wk to use as you
please
2. Your hourly wage is $25 per hour

• At one extreme, you can work not-at-all and have 80 hours of leisure
• At the other extreme, you can work 80 hours. No leisure, but 80*25 =
$2000 of income per week

• In between, for every hour of work, you gain $25 but lose 1 hour of leisure
• A budget constraint (BC)!
Econ 101: Principles of Micro 17
Labor supply
Income (dollars)
• Different people value leisure and
market goods differently
• Given the same wage, they prefer $2000
to work different hours

• Your indifference curve represents

your tradeoff between market
goods and non-market goods
U*
• Just like in chapter 10, utility is +$25
maximized when the indifference -1 hour
curve and BC are tangent 35 80
Leisure (hours)
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Labor supply
Income (dollars)
• Since you chose to have 35 hours
of leisure, you chose to work for
80 – 35 = 45 hours
$2000
• 45 * $25 = $1,125 weekly income

• Labor supply is the relationship

between changes in wages and $1125
changes in willingness-to-work.
U*
• When wages fall, the relative value +$25
of work falls. -1 hour
35 80 Leisure
45 hours work (hours)
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Labor supply
• When wages fall, the relative value of work falls.
• Can think of this two ways:
a. An hour of work offers less reward: it allows you to buy less stuff
b. The opp cost of leisure is smaller, so the net benefit of leisure is
greater

• Depending on preferences, as wages fall, some people will

1. Work MORE: each hour earns less money, so they ‘make up for it’ by
working more hours
2. Work the SAME: “I work full time, no more, no less”
3. Work LESS: leisure is now cheaper, so ‘buy’ more of it, by spending
less time at work.
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Labor supply
Income
• Wages fall from $25  $20
• BC flattens
• Now only 80*$20 = $1600 is the $2000
max weekly market income
$1600
• Some people Old optimum
$1125
• Work more $1000
U*
U*

30 35 80
50 hours work leisure
Econ 101: Principles of Micro 21
Labor supply
Income
• Wages fall from $25  $20
• BC flattens
• Now only 80*$20 = $1600 is the $2000
max weekly market income
$1600
• Some people Old optimum
$1125
$850
• Work the same
U*

35 80
45 hours work leisure
Econ 101: Principles of Micro 22
Labor supply
Income
• Wages fall from $25  $20
• BC flattens
• Now only 80*$20 = $1600 is the $2000
max weekly market income
$1600
• Some people Old optimum
$1125

$650
U*
• Work less

35 45 80
35 hours work leisure
Econ 101: Principles of Micro 23
Labor supply
• Turns out, it’s hard to predict how individual labor supply changes with the
price of labor.
• Since lower wages make you poorer, and people don’t like that, it’s not
unreasonable to think that when the reward to labor falls, people choose
to work MORE, to “make up” some for the loss.

• Labor supply, in the data, is very inelastic / insensitive to wages

• For the average working-age man, the price-elasticity of labor supply
is around 0 – 0.1
• Most just work full time, 40 hours and that’s that.
• For the average working-age woman in the labor market, its around
0.3 – 0.5. More sensitive than men, but still pretty inelastic
Econ 101: Principles of Micro 24
Labor supply
• When wages rise and people work more, we say “the substitution effect
dominates”
• The substitution effect says that when something is more valuable at the
margin, you want more of that thing
• In this case, when labor is more valuable, you offer more labor

• When wages rise and people work less, we say “the income effect
dominates”
• The income effect says that when your income rises, you tend to buy
more of everything
• In this case, you buy more non-market goods. More leisure means less
labor
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Labor supply
• What shifts the labor supply curve?
1. Preferences or social norms
• Who is expected to “stay home with the kids?” How have video
games & the internet changed the value of leisure?
2. Population – more working-age people means more workers
• If population stays the same, but average age rises, labor supply can
fall as a greater fraction of the population is retired
3. Job opportunities
• Think of women’s participation in the market over the last 60 years
• More supply in business, less in teaching
4. Wealth – a greater stock of money means less need for income / work

Econ 101: Principles of Micro 26

Labor supply
• Add up individual hours w
LS
worked at every wage to get
market labor supply

• In most situations, it’s

reasonable to draw the $13
market labor supply as an
upward-sloping line, as usual.

• Put supply and demand

together, and we get LD
equilibrium market wage.
Market for candy factory labor L

Econ 101: Principles of Micro 27

Labor supply
• In competitive markets, labor demand is the value of the marginal product
of workers.

• Labor supply represents the interaction of the way we trade off the value of
market and non-market goods (leisure), given social and practical
constraints.

• Together, they give us wage in a given labor market (for a given ‘type’ of
worker)

• This gets us well along the way to thinking about income distribution

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 Next:
Inequality and poverty

Econ 101: Principles of Micro 29