finance

Finance 101: Monetary Economics & the Global Economy

Lecture 5The labor marketProf. Taschereau-DumouchelSpring 2013

FNCE 101 - Kurmann - Lecture 5

**OutlineLabor demand (by firms)Labor supply (by people)Labor market equilibriumWhy do the French work less?

**Readings and ProblemsReadingsABC, chapters 3.2 3.4

Practice problemsABC chapter 3Review questions 6, 7, 9Numerical questions 3, 5, 6Analytical questions 2, 4, 5

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Factor Demands by Firms*

*Labor demandAssumeCapital stock is fixed in the short run (we will relax that later)Capital takes time to adjustFocus on demand for laborWorkers are identicalPerfect competition on product and labor marketFirms have no control over prices and wagesFirms maximize profits

NotationNotations : P = price level of the unique goodY = real GDPW = nominal wage (in $)w = W/P = real wageUC = nominal user cost of capital, or rental price of capitaluc = UC/P = real user cost of capital*

Labor Demand by FirmsFirms maximize profitsIn nominal terms: Profits = Revenue Costs

P.Y = total sales revenue (in $)W.N = total wage bill (in $)UC.K = income accruing to capital holder (in $)*

Labor Demand by FirmsMaximization problem :Given a stock of capital K, choose N to maximize profits.

Represent firms problem by the following mathematical problem:*

Solving Firms Problem

This is a constrained maximization problem :How should we deal with the constraint ?Simply by substituting in the objective function :*

Solving the Firms ProblemHolding P, W, UC, A and K fixed, we solve for the optimal labor N :Derive the first order condition (FOC) :

With Cobb-Douglas: (1-a)AKaN-a = (1-a)Y/N = W/P = w

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Intuition*Intuition for the result:With fewer workers, MPN > W/P, so much more gains to makes.The revenue from an extra worker exceeds the cost, so hire more.Hire more until at some point MPN = W/PIf hire too much, MPN < W/P, so start making losses!The revenue from extra workers less than the cost so lay them off.

Effect of an Increase in the WageIf the real wage W/P increases:The slope of the cost function becomes steeperDiminishing returns: N must decrease so that MPN=W/PConclusion : Labor demand N is a decreasing function of W/P*

Demand for LaborAggregate labor demand Nd is sum of firms individual demand.As the real wage increases, labor demand by firms decreases

*NdNW/P

Effect of an increase in A

If A increases from A1 to A2 (A1 < A2) :Each worker produces more for a given wage, so firms are more willing to hire themThe demand for labor increases

*P.A1F(K,N)W.NNN1N2P.A2F(K,N)

Effect of an increase in AIf A increases from A1 to A2 (A1 < A2) :The labor demand shifts to the right*NdNW/P

Cobb-Douglas ExampleAssume :

N decreases with the real wage wN increases with A and K :More capital per worker implies that workers are more productive.Firms are more willing to hire them (given a fixed wage)*

Labor supply

The supply of labor is determined by individualsAggregate supply is the sum of individuals labor supply.Individuals labor supply depends on labor-leisure choice

Two simultaneous effects :Substitution effect (SE) : Higher real wage encourages work, since reward for working is higher (opportunity cost of leisure is higher)Income effect (IE) : Higher real wage increases income for same amount of work time, so person can afford more leisure, so will supply less labor.

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Theoretical AnalysisEffect of an increase in the real wageNote : the price (opportunity cost) of leisure is the real wage2 simultaneous effects :Substitution effect : leisure is now more expensiveconsume less leisure work more

Income effect : individuals feel wealthier consume more leisure work less

The theory alone does not tell us which effect dominates. It all depends on peoples preferences look in the data!

*Labor supply increasesLabor supply decreases

Substitution vs Income Effects*NSNSNS

Factors that Affect Labor SupplyWealthGreater wealth reduces labor supply (income effect)

Expected increase in future real wageLike an increase in wealth so reduces labor supplyThe longer the high wage is expected to last the larger is the income effect

Working age population and labor force participation rateBoth increase labor supply*

Empirical EvidenceSuppose the real wage increase :For a temporary increase in real wages, labor supply increasesSubstitution effect dominates.For a permanent increase in real wages, labor supply decreasesIncome effect dominatesBusiness cycles, we usually assume that substitution dominates :*NS

Labor Market EquilibriumWe have modeled both sides of the labor market :Demand (firms) : Nd(W/P)Supply (workers) : Ns(W/P)

How does the labor market reach an equilibrium?In particular, how are wages determined?*

Labor Market Equilibrium

Equilibrium : Nd(W/P) = Ns(W/P)The real wage is such that supply equals demandAt N*, the economy is at full employment*Labor,NReal wage, W/PNSNDw*N*

Labor market equilibriumNotice that there is no unemploymentNot realistic (see later how to deal with it)In particular, need to assume that wages are flexible : Unemployed workers willing to accept wage cuts in order to find job. This prevent the existence of unemployment.In reality : wages seem rigid and take time to adjust.This equilibrium concept describes labor markets in the long-runWhen wages and prices have fully adjusted.*

There is never unemployment in classical labor market equilibriumFNCE 101 - Kurmann - Lecture 6*AssumptionsAll jobs and workers are the sameThere is perfect informationReal wages adjust instantaneously

FNCE 101 - Kurmann - Lecture 5

Full EmploymentFull-employment Output = Potential OutputWe wait for the wage to adjust fullyPotential output = level of output when labor market is in equilibrium

Potential output can be affected by changes in full employment level, productivity and other kinds of supply shocks*

*Full employment outputNYAF(K,N)NwNSND

Application 1: Oil shocks*

*Effect of a (temporary) oil shockNYAF(K,N)NwNSND

*Effect of oil shockOil shocksSharp oil price increases in 19731974, 19791980, 20032005

EffectsAdverse supply (or TFP) shocklowers labor demand, employment, the real wage, and the full-employment level of outputFirst two episodes: U.S. economy entered recessions and real wage fellLast episode: U.S. economy didnt enter recession and real wages didnt fall

Why do the French work less?In 2004, French GDP/capita was about 30% below U.S. GDP/capita, mostly because the French worked much less (both less employment and less hours worked per employee).Do the French have a bigger preference for leisure than Americans?Or are there are other possible explanations?*

Taxes and employmentLabor NReal wage wNS(without taxes)ND(without taxes)

Taxes and employmentLabor NReal wage wNS(without taxes)ND(without taxes)NS(with labor income taxes)

Taxes and employmentLabor NReal wage wNS(without taxes)ND(without taxes)NS(with labor income taxesand consumption taxes)

Taxes and employmentLabor NReal wage wND(without taxes)ND(with taxes onfirm revenue orfirms capital)N*w*NS(with labor income taxesand consumption taxes)NS(without taxes)

Taxes and employmentPrescott (2002)

SummaryLabor demand (ND): amount of labor that firms are willing to hire for a given wage (derived from profit maximization)Labor supply (NS): amount of labor that individuals are willing to supply for a given wage (derived from utility maximization)Classical labor market equilibrium: wage for which ND = NSPresumes that wages adjust quicklyDescribes full employment situationProblems with classical modelCant study unemploymentMaybe wages dont adjust that quicklyDifferences in tax rates can explain why French work less than Americans

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Reading for next lectureABC Chapter 3.5, 11.1*

*********What does lazy mean in our model?****No Taxes Levied on Firm MPN = w Tax on Firm Revenue (expenses not deductible)(1-t)(MPN) = wTax on Profits(1-t)(MPN) = (1-t)w, so MPN = w

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