© 2009 Pearson Education Canada 12/1 Chapter 12 Labour Market Applications.

© 2009 Pearson Education Canada12/1

Chapter 12Chapter 12

Labour Market ApplicationsLabour Market Applications


Minimum Wage LegislationMinimum Wage Legislation

The real question regarding minimum The real question regarding minimum wage legislations is, “do they help the wage legislations is, “do they help the working poor?”working poor?”

- Does it achieve a desired redistribution of Does it achieve a desired redistribution of income?income?

- Are workers in the industry “better-off”?Are workers in the industry “better-off”?- Whose income falls to make up for the Whose income falls to make up for the

rise in minimum wage income?rise in minimum wage income?- Is inefficiency an invariable side effect?Is inefficiency an invariable side effect?


Figure 12.1 Minimum-wage legislation Figure 12.1 Minimum-wage legislation in a competitive labour marketin a competitive labour market


Minimum Wage in a Competitive Minimum Wage in a Competitive Labour MarketLabour Market

In a competitive market, inefficiency is a In a competitive market, inefficiency is a necessary by-product of an effective minimum necessary by-product of an effective minimum wage law.wage law.

As labour services are no longer put to their As labour services are no longer put to their most productive uses, either unemployment or most productive uses, either unemployment or underemploymentunderemployment will signal that will signal that inefficiency.inefficiency.

Underemployed workers in Figure 12.1 are Underemployed workers in Figure 12.1 are those who have a marginal product of $12 in those who have a marginal product of $12 in this industry, but choose to work in a less this industry, but choose to work in a less productive industry rather than face the productive industry rather than face the chance of unemployment.chance of unemployment.


Monopsonistic Labour MarketsMonopsonistic Labour Markets

A monopsonistic labour market has a A monopsonistic labour market has a single buyer of labour.single buyer of labour.

The implications of minimum-wage The implications of minimum-wage legislation are very different compared to legislation are very different compared to a competitive market.a competitive market.

Figures 12.2 and 12.3 illustrate why this Figures 12.2 and 12.3 illustrate why this is the case.is the case.


Figure 12.2 Minimum wage and a Figure 12.2 Minimum wage and a monopsonist’s marginal factor costmonopsonist’s marginal factor cost


From Figure 12.2From Figure 12.2 Once a minimum wage is brought into Once a minimum wage is brought into

a monopsony, the marginal factor cost a monopsony, the marginal factor cost (MFC) will change. (MFC) will change.

The monopsonist’s pre-legislation MFC The monopsonist’s pre-legislation MFC is the line segment DBC.is the line segment DBC.

The post-legislation MFC is now two The post-legislation MFC is now two lines, w’A and BC. lines, w’A and BC.


From Figure 12.2From Figure 12.2

If the monopsonist hires an amount of If the monopsonist hires an amount of labour less than z’, its MFC is w’.labour less than z’, its MFC is w’.

If it hires beyond that point, its MFC is If it hires beyond that point, its MFC is segment BC of its original MFC function segment BC of its original MFC function because it can hire additional workers because it can hire additional workers only at a wage rate higher than w’.only at a wage rate higher than w’.


Figure 12.3 Minimum wage and monopsonyFigure 12.3 Minimum wage and monopsony


From Figure 12.3From Figure 12.3 Does a minimum wage increase workers’ incomes? Does a minimum wage increase workers’ incomes? Yes. As long as the wage is not higher than w”’, Yes. As long as the wage is not higher than w”’,

some workers are better off and none worse off. some workers are better off and none worse off. Why?Why?- At w* or below, it has no effect.- At w* or below, it has no effect.- At above w* but below w’’’, workers hired - At above w* but below w’’’, workers hired before the introduction of the minimum before the introduction of the minimum wage will wage will be paid more and new workers will be paid more and new workers will be hired at the be hired at the new (minimum) wage. new (minimum) wage. -- If the rate is w”’, no new workers are hired, If the rate is w”’, no new workers are hired, but existing workers will be paid more.but existing workers will be paid more.



The attractiveness of minimum wage The attractiveness of minimum wage legislation depends upon whether labour legislation depends upon whether labour markets are competitive or markets are competitive or monopsonistic.monopsonistic.

Empirical evidence suggests that labour Empirical evidence suggests that labour markets covered by minimum wage laws markets covered by minimum wage laws are competitive, and the laws are are competitive, and the laws are problematic.problematic.



Workers who remain employed are better Workers who remain employed are better off. It is not clear at whose expense the off. It is not clear at whose expense the gain is made (we do not know who pays).gain is made (we do not know who pays).

By creating unemployment and By creating unemployment and underemployment, the legislation will underemployment, the legislation will hurt some people it was intended to help.hurt some people it was intended to help.


Union Wage RatesUnion Wage Rates

Although analyzing the economic Although analyzing the economic consequences of unionization objectively is not consequences of unionization objectively is not easy, we can move in that direction by easy, we can move in that direction by adapting our minimum-wage analysis to apply adapting our minimum-wage analysis to apply to to union wagesunion wages rates. rates.

In this analysis, the union wage is treated like In this analysis, the union wage is treated like a a wage floor wage floor -- setting a minimum wage paid setting a minimum wage paid in a unionized industry.in a unionized industry.


Figure 12.4 A wage floor in the two-Figure 12.4 A wage floor in the two-sector model of the labour marketsector model of the labour market



Imposing the Imposing the wage floorwage floor means that means that some workers are reallocated from sector some workers are reallocated from sector 1 to sector 2 and as a result, the wage rate 1 to sector 2 and as a result, the wage rate in sector 2 falls.in sector 2 falls.

Because $6 is less than the competitive Because $6 is less than the competitive wage of $9, workers are not allocated to wage of $9, workers are not allocated to their most productive jobs. their most productive jobs.

The The wage floorwage floor yields an equilibrium with yields an equilibrium with underemployment.underemployment.



Assume there are unionized and non-Assume there are unionized and non-unionized sectors and that the unionized unionized sectors and that the unionized sector is characterized by a “shape up” (all sector is characterized by a “shape up” (all members turn up each day and a union members turn up each day and a union official picks the members who work that official picks the members who work that day).day).

Workers are free to seek work in either Workers are free to seek work in either sector. The number of workers looking for sector. The number of workers looking for jobs in the union “shape up” is zjobs in the union “shape up” is z11 and and those looking in the non-unionized sector is those looking in the non-unionized sector is zz2.2.



20 jobs at the union wage of $12 are 20 jobs at the union wage of $12 are shared by all union members. shared by all union members.

Assuming the jobs are shared Assuming the jobs are shared equally, the proportion of time that equally, the proportion of time that any union member will be employed any union member will be employed is 20/zis 20/z11 (jobs/union members).

The expected wage is the union wage ($12) times 20/z1 or 240/z1.


Figure 12.5 Wage floors and search Figure 12.5 Wage floors and search unemployment in a two-sector modelunemployment in a two-sector model



Figure 12.5 is different from 12.4 in that Figure 12.5 is different from 12.4 in that the expected wage rate is plotted in the expected wage rate is plotted in quadrant I.quadrant I.

Notice that the expected wage Notice that the expected wage relationship passes point G in quadrant I relationship passes point G in quadrant I because when 20 union workers look for because when 20 union workers look for jobs in the “shape up” each is employed jobs in the “shape up” each is employed full time at the union wage of $12 per full time at the union wage of $12 per hour. hour.



Suppose the workers continue to join Suppose the workers continue to join the union sector until the expected the union sector until the expected wage in the union sector equals that wage in the union sector equals that on the non-union sector.on the non-union sector.

Equilibrium allocation is at point C in Equilibrium allocation is at point C in quadrant III, with a wage of $8.quadrant III, with a wage of $8.



At equilibrium point C:At equilibrium point C:– 30 unionized workers are chasing 20 union 30 unionized workers are chasing 20 union

jobs paying $12.jobs paying $12.– As unionized workers split available work As unionized workers split available work

equally, the expected wage is equally, the expected wage is $240/30 = $8.$240/30 = $8.



At equilibrium point C:At equilibrium point C:– 70 workers are employed in sector 270 workers are employed in sector 2– Unemployment equals Unemployment equals uu in quadrant I, (10 full in quadrant I, (10 full

time workers).time workers). – Note that in equilibrium in Figure 12.4 (point Note that in equilibrium in Figure 12.4 (point

B in Figure 12.5), 80 non-union workers are B in Figure 12.5), 80 non-union workers are employed in sector 2.employed in sector 2.



It is necessary that the equilibrium wage in It is necessary that the equilibrium wage in sector two of the underemployment model sector two of the underemployment model is lower than that in the unemployment is lower than that in the unemployment model. Why? model. Why?

Because in the unemployment model, Because in the unemployment model, some non-union workers leave sector 2 to some non-union workers leave sector 2 to chase jobs in sector 1.chase jobs in sector 1.

As a result, the smaller number of non-As a result, the smaller number of non-union workers remaining in sector 2 will union workers remaining in sector 2 will earn a higher wage.earn a higher wage.


From Figure 12.5:From Figure 12.5:

Two sources of inefficiency arise in Two sources of inefficiency arise in this model:this model:

1.1. There is unemployment equal to There is unemployment equal to uu in in quadrant I.quadrant I.

2.2. The allocation of workers who are The allocation of workers who are employed is inefficient because the wage employed is inefficient because the wage floor exceeds the equilibrium wage.floor exceeds the equilibrium wage.


Income MaintenanceIncome Maintenance

What institution is best for What institution is best for transferring income to the poorer transferring income to the poorer members of society?members of society?

1.1. Efficient transfer mechanismEfficient transfer mechanism

2.2. Topping-up mechanismTopping-up mechanism

3.3. Negative income taxNegative income tax


Figure 12.6 An efficient income-Figure 12.6 An efficient income-transfer mechanismtransfer mechanism


The Efficient Transfer MechanismThe Efficient Transfer Mechanism

Although the lump-sum mechanism is Although the lump-sum mechanism is efficient, it is not practical.efficient, it is not practical.

There is no systematic way of choosing a There is no systematic way of choosing a target indifference curve or identifying target indifference curve or identifying individual preferences and budgets to individual preferences and budgets to pinpoint recipients.pinpoint recipients.

As a result, policies are formulated in terms As a result, policies are formulated in terms of of income-maintenance mechanismsincome-maintenance mechanisms rather than rather than utility-maintenance utility-maintenance mechanisms. mechanisms.


Income-Maintenance ProgramsIncome-Maintenance Programs

Income-maintenance programsIncome-maintenance programs have the have the objective of raising the income of anyone objective of raising the income of anyone below a targeted level of income, up to below a targeted level of income, up to that level.that level.

In practical income-maintenance schemes, In practical income-maintenance schemes, the amount of the income transfer is the amount of the income transfer is conditional upon the amount of the conditional upon the amount of the recipient’s earned income.recipient’s earned income.


Topping Up and WelfareTopping Up and Welfare

The essential feature of many welfare The essential feature of many welfare programs is a programs is a topping-up topping-up mechanismmechanism, where the subsidy is just , where the subsidy is just large enough to put the recipient at large enough to put the recipient at the mandated income level.the mandated income level.

The result is that potential recipients The result is that potential recipients can affect the amount of income can affect the amount of income transferred to them by choosing how transferred to them by choosing how much income they earn.much income they earn.



If the potential recipient earns as much If the potential recipient earns as much or more than the targeted income level or more than the targeted income level (S’), he/she will not get any subsidy.(S’), he/she will not get any subsidy.

If he/she earns an income below S’, the If he/she earns an income below S’, the amount of the subsidy will be just amount of the subsidy will be just enough to raise total income to S’.enough to raise total income to S’.

This topping-up mechanism translates This topping-up mechanism translates into the kinked budget line in Figure into the kinked budget line in Figure 12.7. 12.7.



This topping-up mechanism translates This topping-up mechanism translates into the kinked budget line in Figure into the kinked budget line in Figure 12.7, which leads to inefficiency. 12.7, which leads to inefficiency.

The inefficiency occurs because the The inefficiency occurs because the recipient’s MRS at recipient’s MRS at E,E, is less than the is less than the wage rate.wage rate.


Figure 12.7 An inefficient Figure 12.7 An inefficient income-transfer mechanismincome-transfer mechanism


The Negative Income TaxThe Negative Income Tax

The The negative income tax (NIT) negative income tax (NIT) combines combines the elements of the efficient lump-sum the elements of the efficient lump-sum transfer and the topping-up mechanism.transfer and the topping-up mechanism.

Though not problem-free, this combined Though not problem-free, this combined scheme redistributes income to poorer scheme redistributes income to poorer members of society without the gross members of society without the gross inefficiency and the perverse lack of work inefficiency and the perverse lack of work incentives associated with the welfare system.incentives associated with the welfare system.


Figure 12.8 A negative income taxFigure 12.8 A negative income tax



This version of the NIT combines an This version of the NIT combines an unconditional income transfer for everyone unconditional income transfer for everyone ((SS’’) and a proportionate (yet moderate) ’’) and a proportionate (yet moderate) income tax (income tax (tt) on earned income.) on earned income.

Everyone receives the subsidy (S’’), pays Everyone receives the subsidy (S’’), pays twhtwh in taxes, keeps in taxes, keeps (1-t)wh(1-t)wh from his/her earned from his/her earned income, and receives net income equal to:income, and receives net income equal to:

xx2 = S”+ (1-t)wh



At point E in Figure 12.8, the budget line At point E in Figure 12.8, the budget line is tangent to the indifference curve and is tangent to the indifference curve and the person is indifferent between the NIT the person is indifferent between the NIT and the topping-up mechanism.and the topping-up mechanism.

This person works This person works h*h* hours and earns hours and earns income equal to income equal to wh*.wh*.



Point E is not an efficient equilibrium Point E is not an efficient equilibrium because the MRS is less than because the MRS is less than ww..

The NIT offsets some of the inefficiencies The NIT offsets some of the inefficiencies associated with the topping-up associated with the topping-up mechanism and avoids the disincentive to mechanism and avoids the disincentive to work.work.

It also makes smaller demand on the It also makes smaller demand on the public purse (DE for the NIT versus S’ for public purse (DE for the NIT versus S’ for the topping-up mechanism).the topping-up mechanism).


The Market for SuperstarsThe Market for Superstars

Figure 12.9 shows two separate labour Figure 12.9 shows two separate labour markets. There is a market demand and markets. There is a market demand and supply curve for talent levels of supply curve for talent levels of t=0.25t=0.25 and the same for talent levels of and the same for talent levels of t=0.35t=0.35..

Consumers are willing to pay more for Consumers are willing to pay more for talented singers and we assume they talented singers and we assume they can produce more CDs.can produce more CDs.


Figure 12.9 Labour markets with Figure 12.9 Labour markets with different levels of talentdifferent levels of talent


The market for SuperstarsThe market for Superstars

A superstar market is characterized by a A superstar market is characterized by a good or service that has a poor good or service that has a poor substitutability between quantity and substitutability between quantity and quality.quality.

Also a small number of individuals are Also a small number of individuals are able to supply the entire market. able to supply the entire market.

More talented labour produces more CDs More talented labour produces more CDs and gets a higher wage.and gets a higher wage.

© 2009 Pearson Education Canada 12/1 Chapter 12 Labour Market Applications.

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