Labor Market Equilibrium

Lecture 4: The Demand for Labor

Labor Market Equilibrium1Hwei-Lin Chuang, Ph.D.2014/04/17::-2:()4:-11111-1613-2828411246()430

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16.028.525.418.028.827.924.425.227.28IntroductionLabor market equilibrium coordinates the desires of firms and workers, determining the wage and employment observed in the labor market.

Market types:Perfect CompetitionMonopsony: one buyer of laborMonopoly: one seller of product

These market structures generate unique labor market equilibria.9Labor Market EquilibriumWorkers prefer to work when the wage is high, and firms prefer to hire when the wage is low. Labor market equilibrium balance out the conflicting desires of workers and firms and determines the wage and employment observed in the labor market.101. Equilibrium in a Single Competitive Labor MarketThe supply curve gives the total number of employee-hours that agents in the economy allocate to the market at any given wage level; the demand curve gives the total number of employee-hours that firms in the market demand at that wage. Equilibrium occurs when supply equals demand, generating the competitive wage w * and employment E *.Equilibrium in a Competitive Labor Market Employment Dollars E* W* DSNote: There is no unemployment in a competitive labor market. Persons who are not working are also not looking for work at the going wage.1111Note: The single wage property of competitive equilibrium has important implications for economic performance. That is, workers of given skills have the same value of marginal product of labor in all markets. The allocation of workers to firms which equates the value of marginal product across markets is also the allocation which maximizes national income. This type of allocation is called an efficient allocation.1212(Pareto) EfficiencyPareto efficiency exists when all possible gains from trade have been exhausted.

When the state of the world is Pareto Efficient, to improve one persons welfare necessarily requires decreasing another persons welfare.

In policy applications, ask whether a change can make any one better off without harming anyone else. If the answer is yes, then the proposed change is said to be Pareto-improving.13Equilibrium in a Competitive Labor MarketS

w*PQE*EHELDollarsEmploymentThe 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. The triangle P gives the producer surplus; the triangle Q gives the worker surplus. A competitive market maximizes the gains from trade, or the sum P + Q.14D0Efficiency RevisitedThe single wage property of a competitive equilibrium has important implications for economic efficiency.Recall that in a competitive equilibrium the wage equals the value of marginal product of labor. As firms and workers move to the region that provides the best opportunities, they eliminate regional wage differentials. Therefore, workers of given skills have the same value of marginal product of labor in all markets.The allocation of workers to firms that equates the value of marginal product across markets is also the sorting that leads to an efficient allocation of labor resources. 152. Competitive Equilibrium Across Labor Markets The economy typically consists of many labor markets, even for workers who have similar skills. As long as either workers or firms are free to enter and exit labor markets, a competitive economy will be characterized by a single wage. Dollars Employment DNSNW* Dollars Employment DSSSW*SNWNSSWSCompetitive Equilibrium in Two Labor Markets Linked by Migration1616Competitive Equilibrium Across Labor MarketsIf workers were mobile and entry and exit of workers to the labor market was free, then there would be a single wage paid to all workers.The allocation of workers to firms equating the wage to the value of marginal product is also the allocation that maximizes national income (this is known as allocative efficiency).The invisible hand process: self-interested workers and firms accomplish a social goal that no one had in mind, i.e., allocative efficiency.17(FTA)18

(FTA)The Obama Administration finalized negotiations with South Korea in early December 2010 on a bilateral free trade agreement. As a result, the administration is expected to submit implementing legislation to the 112th Congress on the proposed agreement, but to date has not indicated a timeline for doing so. The 112th Congress may also be asked to consider implementing legislation for proposed free trade agreements with Columbia and Panama. Congress not only plays a direct role in approving legislation that implements the provisions of free trade agreements, but also authorizes and appropriates funding for programs that are meant to provide special assistance to firms and workers that are dislocated as a result of lower barriers to trade. Since the proposed agreement covers a wide range of trade and investment issues, it could have substantial economic implications for both the United States and South Korea. South Korea is the seventh-largest trading partner of the United States, and the United States is South Koreas third-largest trading partner.19(FTA)Similar to other trade agreements, the proposed U.S.-South Korea Free Trade Agreement(KORUS-FTA) has attracted both supporters and detractors, primarily over the impact the agreement could have on employment in the economy. Supporters argue that the agreement could create as many as 280,000 jobs in the economy. Others, however, argue that the agreement could lead to an overall loss of up to 159,000 jobs in various sectors of the economy. Still others contend that the United States stands to lose exports, employment, and extended economic opportunities if it fails to sign a trade agreement, while the European Union and other nations are lining up to finalize similar agreements with South Korea.Estimating the economic impact of trade agreements, however, is a daunting task, due to a lack of data and important theoretical and practical matters associated with generating results from economic models. In addition, such estimates provide an incomplete accounting of the total economic effects of trade agreements. This report assesses the results of a number of models that are being used to generate estimates of the effect of the KORUS FTA on employment.20(FTA)These studies were chosen specifically because they estimate (or can be used to estimate) data on employment effects of the trade agreement. All economic models incorporate various assumptions that are necessary in order for the model to generate results. Invariably, these approaches determine, to some extent, the results that are generated and, therefore, limit their representation of the real world economy. Currently, the various models produce widely disparate estimates of the number of jobs affected by the trade agreement, reflecting the various assumptions that are used in the models and differences in the approaches.From the perspective of a large open economy such as the U.S. economy, international trade is not a major determinate of total employment in the economy, real wages in the economy, or the overall level of production. This is especially true for bilateral trade agreements with individual countries where the impact on the economy as a whole is expected to be small. Nevertheless, some sectors of the economy are likely to be affected more than others. Congress has demonstrated an ongoing interest in assessing the economic impact of trade agreements and, at times, has provided assistance to those workers and firms that are disproportionately affected.21(FTA):

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3. THE COBWEB MODELOur analysis of labor market equilibrium assumes that markets adjust instantaneously to shifts in either supply or demand curves, so that wages and employment change swiftly from the old equilibrium levels to the new equilibrium level. Many labor markets, however, do not adjust so quickly to shifts in the underlying supply and demand curves.Example: the Engineering Market Note: The adjustment of college enrollments to changes in the returns to education is not always smooth or rapid, particularly in fields that are highly technical. The inability to respond immediately to changed market conditions can cause boom-and-bust cycles in the market for highly technical workers.2424WageNumber of Engineers DSDN0N2N3N1W2W0WeW3W1Demand increase to Dtemporary supply is N0 W increase to W1 W1 wage induce increase in supply to N1 excess supply W reduce to W2 W2 wage reduce supply to N2 W increase to W3 at W3 , supply increase to N3 excess supply W reduces, etc.25Overtime the swings become smaller and eventuallyequilibrium is reached. cobweb model.Note: There are two key assumptions in the cobweb model:It takes time to produce new engineers, so that the supply of engineers can be thought of as being perfectly inelastic in the short run.Students are very myopic when they are considering whether to become engineers.26264. POLICY APPLICATION: PAYROLL TAXESPayroll taxes on employers are heavily used in the social insurance area. With our simple labor model, we can show that the party making the social insurance payment is not necessarily the one that bears the burden of the tax.Tax Employment S0D0D1Real WageE0E1E2W1W0W1+XW0+Tax is a fixed dollar amount X. D0D1 with vertical distance of X. pt. A: excess supply real wageEmployees bear part of the burden of the payroll tax in the form of lower wage rates and lower employment levels. Note: In general, the extent to which the labor supply curve is sensitive to wages determines the proportion of the employer payroll tax that gets shifted to employees wages. 2727Payroll Taxes and SubsidiesPayroll 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 and the wage received by workers declines.Payroll taxes result in deadweight losses.28The Impact of a Payroll Tax Assessed on WorkersDollarsw1w0S0D0

D1

E1E0EmploymentS1w0 + 1w1 1

A payroll tax assessed on workers shifts the supply curve to the left (from S0 to S1). The payroll tax has the same impact on the equilibrium wage and employment regardless of who it is assessed on.29The Impact of a Payroll Tax put on Firms with Inelastic SupplyDollarsw0D0S

D0D1E0ABEmploymentw0 1A payroll tax assessed on the firm is shifted completely to workers when the labor supply curve is perfectly inelastic. The wage is initially w0. The $1 payroll tax shifts the demand curve to D1, and the wage falls to w0 1.30Payroll SubsidiesAn employment subsidy lowers the cost of hiring for firms.

This means payroll subsidies shift the demand curve for labor to the right (up).

Total employment will increase as the cost of hiring has fallen.31The Impact of an Employment SubsidyAn employment subsidy of $1 per worker hired shifts up the labor demand curve, increasing employment. The wage that workers receive rises from w0 to w1. The wage that firms actually pay falls from w0 to w1 1.w1SD1D0w0E0E1BAEmploymentw0 + 1w1 1 3220141119,0476331153.8233 - 196860019842119861121193612111223231986123

34 - ()1988199715,840200720079%20107

35201220128931.4219,0471091968362012()92620131110918,7803%4%20134142119,0473720132013828262014109115201471190471927392420143%385. Policy Application: The Impact of Minimum WagesThe standard economic model of the impact of minimum wages on employment is illustrated in the following figure:The Impact of the Minimum Wage on EmploymentNote: A minimum wage creates unemployment both because some previously employed workers lose their jobs, and because some workers who did not find it worthwhile to work at the competitive wage find it worthwhile to work at the higher minimum wage. Dollars E* W* DS ES WE Employment 3939The Impact of Minimum Wages on the Covered and Uncovered SectorsSUDollarsDollarsSCEmploymentEUEUEUECEmployment(b) Uncovered SectorE SUSUw w*w*DUDC(If workers migrate to covered sector)(If workers migrate to uncovered sector)(a) Covered SectorIf the minimum wage applies only to jobs in the covered sector, the displaced workers might move to the uncovered sector, shifting the supply curve to the right and reducing the uncovered sectors wage. If it is easy to get a minimum wage job, workers in the uncovered sector might quit their jobs and wait in the covered sector until a job opens up, shifting the supply curve in the uncovered sector to the left and raising the uncovered sectors wage. 40Note: In the absence of a minimum wage, the migration of workers across sectors equates the wage in the two sectors. The migration of workers when the wage in one of the markets is set at the minimum wage equates the expected wage across sectors. I.e., the free migration of workers across sectors ensure that the expected wage in the covered sector equals the for-sure wage in the uncovered sector.41416. Noncompetitive Labor MarketsMonopsony Because the firm is the only demander of labor in this market, it can influence the wage rate. Monopsnoists face an upward-sloping supply curve. This is because the supply curve confronting them is the market supply curve.

Note: To expand its work force, a monopsonist must increase its wage rate, i.e., the marginal cost of hiring labor excess the wage.

4242Noncompetitive Labor Markets: MonopsonyMonopsony market exists when a firm is the only buyer of labor.

Monopsonists must increase wages to attract more workers.

Two types of monopsonist firms:Perfectly discriminatingNondiscriminating43Perfectly Discriminating MonopsonistDiscriminating monopsonists are able to hire different workers at different wages.

To maximize firm surplus (profits), a perfectly discriminating monopsonist perfectly discriminates by paying each worker his or her reservation wage.44The Hiring Decision of a Perfectly Discriminating MonopsonistA perfectly discriminating monopsonist faces an upward-sloping labor supply curve and can hire different workers at different wages. Therefore the labor supply curve gives the marginal cost of hiring. Profit maximization occurs at point A. The monopsonist hires the same number of workers as a competitive market, but each worker is paid his or her reservation wage.DollarsSVMPEEmploymentw*w30w103010E*A45Nondisriminating MonopsonistMust pay all workers the same wage, regardless of each workers reservation wage.

Must raise the wage of all workers when attempting to attract more workers.

Employs fewer workers than would be employed if the market were competitive.46The Hiring Decision of a Nondiscriminating Monopsonist

A nondiscriminating monopsonist pays the same wage to all workers. The marginal cost of hiring exceeds the wage, and the marginal cost curve lies above the supply curve. Profit maximization occurs at point A; the monopsonist hires EM workers and pays them all a wage of wM.47To maximize profits, we know that any firm should hire labor until the points at which marginal revenue product equals marginal cost.MRP = MCLWLMRPSMCLEmEcWmWCWages are below marginal revenue product for a monopsonist. Wm < WC and Em < EC4848 The Impact of the Minimum Wage on a Nondiscriminating MonopsonistMCEDollarsSAw w*wMVMPEEEMEmploymentThe minimum wage may increase both wages and employment when imposed on a nondiscriminating monopsonist. A minimum wage set at w increases employment to E.49(2) Monopoly A monopoly trying to maximize profits and facing a competitive labor market will hire workers until its marginal revenue product equals the wage rate:

MRP = (MPL)(MR) = W (MR/P)(MPL) = (W/P)