mod 3 econ

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Labour Market - Demand for Labour

The labour market

Although over three million people in the UK are classified as self-employed, the vastmajority of people in work in the UK are employed by private sector businesses, thegovernment and a range of unincorporated businesses. The working of the labour marketaffects us all because the vast majority of people at some point during their working lives willbe active participants in the labour market.

The demand for labour comes from the employer. We shall start with this side of the market.Then we move onto the issue of labour supply before analysing the determination of wagerates in competitive and imperfectly competitive labour markets.

Product and labour markets

We often make a distinction between product and labour markets.

Product markets are where businesses and consumers meet to buy and sell the output ofgoods and services produced by an economy.

The labour market provides a means by which employers find the labour they need, whilstmillions of individuals offer their labour services in different occupations. A simplified set ofrelationships is shown in the flow chart below.

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The demand for labour

There is normally an inverse relationship between the demand for labour and the wage ratethat a business needs to pay for each additional worker employed. If the wage rate is high, itis more costly to hire extra employees. When wages are lower, labour becomes relativelycheaper than for example using capital equipment and it becomes more profitable for the

business to take on more employees.

Standard neo-classical labour market theory assumes that businesses seek to maximiseprofits. They will therefore search in the long run for the mix of factors of production (labourand capital) that produces the required level of output as efficiently as possible for thelowest possible total cost. Of course we can drop the assumption of profit maximisation andthis has implications for employment and equilibrium wages in particular industries oroccupations. But for the moment we will assume that businesses are profit-maximisers whendeciding on their desired demand for labour.

The demand for labour is derived from the demand for the goods and services that workersare asked to produce

Marginal revenue product of labour

Marginal revenue productivity of labour (MRPL) is a theory of the demand for labour andmarket wage determination where workers are assumed to be paid the value of their marginalrevenue product to the business

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm fromselling the output produced by additional workers employed.

MRPL = Marginal Physical Product x Price of Output per unit

o Marginal physical product is the change in output resulting from employing one extra

worker

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o The price of output is determined in the product market in other words, the price

that the firm can get in the market for the output that they have produced

A simple numerical example of marginal revenue product is shown in the next table:

Labour Capital (K) Output (Q) MPP price () MRP = MPP x P ()

0 5 0 5

1 5 30 30 5 150

2 5 70 40 5 200

3 5 120 50 5 250

4 5 180 60 5 300

5 5 270 90 5 450

6 5 330 60 5 300

7 5 370 40 5 200

8 5 400 30 5 150

9 5 420 20 5 100

10 5 430 10 5 50

We are assuming in this example that the firm is operating in a perfectly competitive marketsuch that the demand curve for its output is perfectly elastic at 5 per unit. Marginal revenueproduct follows directly the behaviour of marginal physical product. Initially as more workersare added to a fixed amount of capital, the marginal product is assumed to rise. Howeverbeyond the 5th worker employed, extra units of labour lead to diminishing returns. Asmarginal physical product falls, so too does marginal revenue product.

The story is different is the firm is operating in an imperfectly competitive market where thedemand curve for its product is downward sloping. In the next numerical example we see thatas output increases, the firm may have to accept a lower price. This has an impact on themarginal revenue product of employing extra units of labour.

Labour Capital (K) Output (Q) MPP price () MRP = MPP x P ()

0 5 0 10.0

1 5 25 25 9.60 240

2 5 60 35 9.00 315

3 5 100 40 8.70 348

4 5 150 50 8.20 410

5 5 210 60 7.90 474

6 5 280 70 7.70 539

7 5 360 80 7.00 560

8 5 430 70 6.80 476

9 5 450 20 6.50 130

10 5 460 10 6.00 60

MRP theory suggests that wage differentials result from differences in labour productivity andthe value of the output that the labour input produces. The MRP theory outlined below isbased on the assumption of a perfectly competitive labour market and rests on a number ofkey assumptions that realistically are unlikely to exist in the real world. Most of our labourmarkets are imperfect this is one of the many reasons for the existence and persistence oflarge earnings differentials between occupations which we explore a little later on.

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The main assumptions of the marginal revenue productivity theory of the demand for labourare:

o Workers are homogeneous in terms of their ability and productivity

o Firms have no buying power when demanding workers (i.e. they have no monopsony

power)o Trade unions have no impact on the available labour supply (the possible impact on

unions on wage determination is considered later)o The physical productivity of each worker can be accurately and objectively

measured and the market value of the output produced by the labour force can becalculated

o The industry supply of labour is assumed to be perfectly elastic. Workers areoccupationally and geographically mobile and can be hired at a constant wage rate

The profit maximising level of employment

The profit maximising level of employment occurs when a firm hires workers up to the point

where the marginal cost of employing an extra worker equals the marginal revenue product oflabour. This is shown in the labour demand diagram shown below.

Shifts in the labour demand curve

Marginal revenue productivity of labour will increase when there is

o An increase in labour productivity (MPP) e.g. arising from improvements in the

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quality of the labour force through training, better capital inputs, or bettermanagement.

o A higher demand for the final product which increases the price of output so firmshire extra workers and thus demand for labour increases, shifting the labour demandcurve to the right.

o The price of a substitute input e.g. capital rises this makes employing labour moreattractive to the employer assuming that there has been no change in the relativeproductivity of labour over capital

The next diagram shows how this causes an outward shift in the labour demand curve. For agiven wage rate W1, a profit maximising firm will employ more workers. Total employment inthe market will rise.

Limitations of MRPL theory of labour demand

Although marginal revenue product theory is a useful aspect of labour market analysis it is

important to be aware of some of its limitations:

1. Measuring productivity: In many cases it is hard to objectively measure productivitybecause no physical output is produced or the output produced may not be sold at amarket price. This makes it hard to place an exact valuation on the output of eachextra worker. How does one go about measuring the final output of people employedin teaching or the health service? It is easier to measure physical output in industrieswhere a tangible product is produced each day. It is also costly to measure peoples

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productivity.2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state

of labour demand and supply. Public sector workers for example fire-fighters, councilworkers, nurses and teachers may have their pay set according to decisions ofindependent pay review bodies with market forces having only an indirect role in

setting pay-rates3. Self employment and Directors Pay: There are over three million people classified as

self-employed in the UK. How many of these people set their wages according to themarginal revenue product of what they produce? What too of those people who havethe ability to set their own pay rates as directors or owners of companies?

Workers employed on a construction site. In some industries it is easier than others tomeasure the physical productivity of workers

Elasticity of labour demand

Elasticity of labour demand measures the responsiveness of demand for labour when there isa change in the ruling market wage rate. The elasticity of demand for labour depends:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of

total costs, then labour demand is more elastic than a business where fixed costs ofcapital are the dominant business expense.

2. The ease and cost of factor substitution: Labour demand will be more elastic when afirm can substitute quickly and easily between labour and capital inputs when therelative prices of each change over time. When the two inputs cannot easily bechanged in the production process (e.g. when specialised labour or capital is needed),then the demand for labour will be more inelastic with respect to the wage rate

3. The price elasticity of demand for the final output produced by a business: If a firm

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is operating in a highly competitive market where final demand for the product isprice elastic, they may have little market power to pass on higher wage costs toconsumers through a higher price. The demand for labour may therefore be moreelastic as a consequence. In contrast, a firm that sells a product where final demand isinelastic will be better placed to pass on higher costs to consumers.

The diagram below shows two labour demand curves with different elasticity

Labour as a Derived Demand

The demand for all factors of production (inputs), including labour, is a derived demand iethe demand for factors of production depends on the demand for the products they produce.When the economy is expanding, we expect to see a rise in the aggregate demand for labourproviding that the rise in output is greater than the increase in labour productivity. Incontrast, during an economic recession or a slowdown, the aggregate demand for labour will

decline as businesses look to cut their operations costs and scale back on production. In arecession, business failures, plant shut-downs and short term redundancies lead to areduction in the derived demand for labour.

Employment change in the UK economyData is for December each year

1990 2005% change

000s 000s 1990-2005

Banking, finance and insurance 4442 6097 27.1

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Total services 20501 24711 17.0

Education and health 6470 7790 16.9

Distribution, hotels & restaurants 6463 7078 8.7

Transport & communication 1680 1839 8.6

Construction 2357 2099 -12.3

Agriculture & fishing 641 446 -43.7Manufacturing 5203 3383 -53.8

Mining, electricity, gas & water 398 171 -132.7

Source: UK Labour Market Statistics

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Derived Demand

Although economists did not formally develop the ideas of economic aggregation prior to the1930s, they used them much earlier. An aggregated market that they saw as a problem marketduring recessions was the market for labor services, or the labor market. On the basis of theirunderstanding of this market, they often suggested that flexibility of prices and wages could cureany fall in output and employment that a drop in total spending might cause. To see why wageflexibility was considered so desirable, we need to explore the idea ofderived demand.

A profit-maximizing employer will hire any resource that produces greater value for him than theresource adds in cost. (This is one way of stating the profit-maximizing condition of the firm.)For simplicity we will assume that the added cost equals the wage or price of the resource (whichimplies that the buyer of the resource is a price taker). The value that the resource contributes

depends on two things: how much output increases, and the extra revenue that each unit of theextra output brings to the firm. To recast this idea into the jargon that only economists enjoy, themarginal revenue product (MRP) of the resource should equal the marginal product (MP) of theresource multiplied by the marginal revenue (MR) of output, or in equation form:

(1) MRP = MP x MR.

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A numerical example may help clarify the idea involved here. Suppose a firm in the garbage-pick-up industry has a fleet of trucks and must pay workers $10.00 per hour. If the firm receives$1.00 for each pickup, and adding another worker will allow it to make 12 more pickups perhour, is it worthwhile to add another worker? Using the rule discussed above, one sees that theextra value to the firm is 12 x $1.00 or $12.00. The extra cost to the firm of hiring another

worker is $10.00. Hence, it is in the interests of the firm to add the extra worker. After thisworker is added, the firm may find that adding another worker will add only nine extra pickupsan hour. In this case an extra worker is not worth adding because to buy an extra $9.00 of incomecosts $10.00.

The marginal revenue product of a resource is in fact the firm's demand curve for the resource.Since the law of diminishing returns says that the marginal product of a resource should declineas more and more of the resource is used, (which can justify the drop in garbage pickups from 12to 9 in the previous paragraph), the demand curve should slope downward to the right. Such ademand curve is shown below. The profit-maximizing amount or labor to hire in this Figure isq*.

Suppose that for some reason people become less willing to buy the product that the firm isproducing. This will affect the demand for resources because this demand is derived from thedemand for output. In terms of equation 1, the drop in the demand for the product affects themarginal revenue of output. This means that even though the resource is as productive as it wasbefore, it now brings less value to the firm because the output it produces is less valuable. Interms of the graph, the drop in marginal revenue of output shifts the demand for the resource tothe left. If the wage does not change, the new equilibrium level of resources hired will be q1 inthe graph below, and this will be achieved by laying-off or firing q1-q* of the resources.

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However, the resources used by the firm do not need to be reduced if the wage or price of theresources falls. If in the graph the wage falls to W1, the same quantity of the resource will beused as was originally used.1 Thus, if wages or prices of resources are fixed, the amounts usedwill vary, while if the amounts used are held constant, then wages and prices must be allowed to

vary.

The same idea can be seen in our garbage problem. If people suddenly reduce the demand forgarbage service, and as a result the firm only gets and extra $.80 for each pickup rather than a$1.00, (notice that this assumes price flexibility), then the extra worker who added 12 pickupswill no longer be worth hiring. Hiring him will still cost $10.00, but now this expenditure of$10.00 only brings the firm $9.60 of extra revenue. For the firm to hire the same number ofworkers, wages must fall (or marginal productivity must rise).

For an individual firm there is no reason to expect the wage to change. The supply curve ishorizontal because each firm is competing with many other firms in different industries for

workers. However, when markets are aggregated, this role of competition is eliminated. Thesupply of labor will no longer be horizontal, but should slope sharply upward. When the demandfor goods drops, less labor will be demanded at old wage rates. The surplus labor should lead to adrop in wages until unemployment is eliminated. In fact, if wages and prices are perfectlyflexible, any drop in spending will cause a drop in prices but no change in output. In such aworld output is not determined by aggregate demand, but by technology and resources. Therewould be no recessions in such a world, only inflations and deflations. However, if wages andprices are not flexible, then a change in total spending will affect output and employment. Thepre-Keynesian economists were well aware that wages and prices did not change readily, andconsidered this inflexibility a major problem.

http://tutor2u.net/economics/revision-notes/a2-micro-demand-for-labour.html

Sticky Wages

Why does a reduction in demand reduce output rather than prices and wages? Although in theearly 1980s some workers accepted reductions in wages and benefits in the hope of protecting

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jobs, this adjustment is uncommon. There are several reasons why it is more common to sacrificeworkers and protect wages.

One reason involves cases in which a union vote is necessary to change contracts. If the choice isbetween no reduction in compensation with a 40% reduction in work force, or a mere 5%

reduction in compensation with no reduction in work force, the former option may win if the60% of the workers who will keep their jobs are easily identified. Since layoffs are usuallydetermined by seniority, those who will keep their jobs are usually identifiable. Hence, it is notin the interests of workers with a great deal of seniority to vote for any reduction incompensation unless the very survival of the organization is at stake.

However, the majority of wage agreements are made without union involvement and in theseagreements reductions in compensation are also uncommon. When the threat of a strike does notexist, workers have other options. They can leave the company if they are unhappy withcompensation, and the ablest workers can most easily move. High turnover raises training costs.In addition, morale is a factor in determining productivity, and any agreement forced on workers

can have effects on morale that might eliminate any advantage that the organization receivesfrom lower wages.

Suppose that management of a company comes to its workers and announces that because ofdifficult economic conditions, it believes that a 10% reduction in wages is in order. How willworkers react? They will have considerable reason to doubt management because a reduction incompensation will always increase profitability. Therefore, management always has the incentiveto ask for lower wages whether or not a reduction is justified by poor economic conditions. Theworkers do not know whether or not management has seriously tried other methods to reducecosts, or even if there is any condition of economic difficulty. Hence, workers often disbelievestatements that pay cuts are needed and fight attempts to cut wages.

On the other hand, when management announces that due to economic difficulties it must lay off10% of the work force, there is usually no reason to doubt their sincerity. Cutting work force willcut output, and in normal periods this cut will reduce profits. Since the potential for abuse doesnot exist in allowing companies to adjust work schedules, but a potential for abuse does exist ifcompanies are allowed to adjust pay schedules at will, workers permit companies the formerright but resist the second with whatever means at their disposal.

A final reason that workers may be unwilling to accept a cut in pay is that they believe that theircurrent wage is an accurate measure of what they are worth. They believe that they could leavetheir present job and find another that will pay them as much. If their wage is cut, they could stayin their present jobs, but that would mean that they would be receiving less than they were worth;the firm would be "exploiting" them. However, leaving and searching for a new job is costly,involving time, risk, and adjustment to a new workplace. Since neither alternative, staying withlower pay or a job search, is attractive, workers resist pay cuts.

One might argue that the above discussion does not explain why an employer cannot simplydischarge all workers and hire new ones if there are plenty of available applicants willing toaccept lower wages. This is an option when unskilled labor is the dominant type of labor, and has

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been a major obstacle in the organization of migrant workers. It is not a good option when on-the-job learning makes new workers less productive than old workers, or when the firm finds itdifficult to separate (orscreen) those applicants who are qualified from those who are not. Also,the law gives certain privileges (or rights) to workers so that discharging them can be expensive.The employer may have to pay either sums to the discharged workers or higher unemployment-

insurance payments. Finally, discharging workers raises a risk of violence and destruction of theemployer's facilities.

A surprising result when quality oflabor depends on wage is that an equilibrium wage mightcoexist with some level of unemployment. Economists have constructed theories in which areduction in demand for labor does not lead to a reduction in wages.

The purpose of the above discussion is to point out reasons why wages do not fall readily. It isnot meant to convince you that wage rates can never fall. They have. From 1929 to 1933, theaverage wage of production workers in manufacturing fell by about 20%. It is probable that withcomparable levels of unemployment, wages would fall even today. If workers are convinced that

their choice is to accept lower wages or have the firm collapse, they will often accept lowerwages. The point of the above discussion is to suggest that until a firm is facing the prospect ofbankruptcy, it finds cutting wages very difficult.

The problem in the labor market is not symmetrical; workers are willing to take higher wagesreadily to adjust to an increase in demand. Employers may not want to increase wages, but eitherthey must or they will lose both existing workers and high-quality applicants. When spendingincreases rapidly, there are fewer rigidities in the labor market and prices and wages will respondmore readily than they would to a fall in demand.

Next we take a look attypes of unemployment.

Measuring Inequality

A second definition of welfare which is often considered in analysis is that of relative poverty, defined as having

little in a specific dimension compared to other members of society. This concept is based on the idea that the

way individuals or households perceive their position in society is an important aspect of their welfare. To a

certain extent, the use of a relative poverty line in the previous sections does capture this dimension of welfare byclassifying as poor those who have less than some societal norm.

The overall level of inequality in a country, region or population group and more generally the distribution ofconsumption, income or other attributes is also in itself an important dimension of welfare in that group.Inequality measures can be calculated for any distributionnot just for consumption, income or other monetaryvariables, but also for land and other continuous and cardinal variables.

Some commonly used measures are presented inTechnical Note: Inequality Measures and theirDecompositions. For a discussion of the properties and qualities of alternative measures, please

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consult Inequality: Methods and Tools(177kb PDF), which presents the five key axioms which inequality areusually required to meet. The paper also discusses the calculation of standard errors for usual measures, which isuseful for comparisons between estimates of inequality for different distributions.

Gini-coefficient of inequality: This is the most commonlyused measure of inequality. The coefficient varies between 0,which reflects complete equality and 1, which indicates

complete inequality (one person has all the income orconsumption, all others have none). Graphically, the Ginicoefficient can be easily represented by the area between theLorenz curve and the line of equality.

On the figure to the right, the Lorenz curve maps thecumulative income share on the vertical axis against thedistribution of the population on the horizontal axis. In thisexample, 40 percent of the population obtains around 20percent of total income. If each individual had the sameincome, or total equality, the income distribution curve wouldbe the straight line in the graph the line of total equality. TheGini coefficient is calculated as the area A divided by the sumof areas A and B. If income is distributed completely equally,

then the Lorenz curve and the line of total equality aremerged and the Gini coefficient is zero. If one individual receives all the income, the Lorenz curve would passthrough the points (0,0), (100,0) and (100,100), and the surfaces A and B would be similar, leading to a value ofone for the Gini-coefficient.

It is sometimes argued that one of the disadvantages of the Gini coefficient is that it is not additive across groups,i.e. the total Gini of a society is not equal to the sum of the Ginis for its sub-groups.

Theil-index: While less commonly used than the Gini coefficient, the Theil-index of inequality has the advantageof being additive across different subgroups or regions in the country. The Theil index, however, does not have astraightforward representation and lacks the appealing interpretation of the Gini coefficient. The Theil index is partof a larger family of measures referred to as the General Entropy class.

Decile dispersion ratio: Also sometimes used is the decile dispersion ratio, which presents the ratio of the

average consumption or income of the richest 10 percent of the population divided by the average income of thebottom 10 percent. This ratio can also be calculated for other percentiles (for instance, dividing the averageconsumption of the richest 5 percent the 95th percentile by that of the poorest 5 percent the 5th percentile).This ratio is readily interpretable, by expressing the income of the rich as multiples of that of the poor.

Share of income/consumption of the poorest x%: A disadvantage of both the Gini coefficients and the Theilindices is that they vary when the distribution varies, no matter if the change occurs at the top or at the bottom orin the middle (any transfer of income between two individuals has an impact on the indices, irrespective ofwhether it takes place among the rich, among the poor or between the rich and the poor). If a society is mostconcerned about the share of income of the people at the bottom, a better indicator may be a direct measure,such as the share of income that goes to the poorest 10 or 20 percent. Such a measure would not vary, forexample, with changes in tax rates resulting in less disposable income for the top 20 percent at the advantage ofthe middle class rather than the poor.

It is possible that different measures will rank the same set of distributions in different ways, because of theirdiffering sensitivity to incomes in different parts of the distribution. When rankings are ambiguous, the alternativemethod of stochastic dominance can be applied. The attached paperInequality: Methods and Tools (177kb PDF)discusses a type of stochastic dominance which can be used for unambiguous comparisons of inequality acrossdistributions: the mean-normalized second-order dominance, or Lorenz dominance.

http://www.economist.com/research/economics/alphabetic.cfm?letter=G

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Measuring Income Distribution

It is possible to measure how equally or unequally aprice system rations by looking at thedistribution of income. The table below shows that during 1978, 20% of households in the

United States (groups of people living together, usually families, or single people if they livealone) had total money incomes of less than $6,391. These people received only 4.3% of the totalincome that households earned. Twenty percent of households earned between $6,391 and$11,955, and these households earned 10.3% of the total income earned. The rest of the table canbe interpreted in the same way.

Percent Distribution of Aggregate Household Income in

1978, by Fifths of Households

Households Percent of Income

Lowest Fifth

(under $6391)4.3

Second Fifth

($6392 - $11955)10.3

Third Fifth

($11956 - $18122)16.9

Fourth Fifth

($18122 - $26334) 24.7

Top Fifth

($26335 and over)43.9

Source: U.S. Bureau of Census, Current Population Reports, P-60, No. 121, "MoneyIncome in 1978 of Households in the United States," Washington, D.C.: U.S. GovernmentPrinting Office, 1980. Data taken from cover. (Data are before taxes.)

The information in the table can be made into a Lorenz curve such as that shown below. Thefurther the Lorenz curve lies below the line of equality, the more unequal is the distribution of

income.

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All economic statistics have problems, and the Lorenz curve and the numbers from which it is

constructed are no exceptions. Problems come from two sources: do the numbers actuallymeasure what they are supposed to measure, and are the numbers accurate?

Income distribution is intended to tell us about the rich and the poor, or about how muchdiscrimination exists in a system of price rationing. In a system of price rationing, however,differences in the ability to use income wisely also determine how much discrimination there is.If those who receive the most income, for example, also tend to be the most capable at using thatincome, then the picture that the Lorenz curve shows will understate the actual amount ofinequality.

If rationing is not done solely by price, but by other methods as well, then looking at income data

may be meaningless. In the United States, most rationing is done with price, but not all. Forexample, the purpose of public housing and food stamps is to prevent rationing by price. Both ofthese items are ignored in the data in the table. Also, one should be cautious when comparingincome distributions among countries because their rationing systems can be very different. Forexample, comparisons of income distribution between the United States and the Soviet Unionwere not meaningful--although economists sometimes made them--because the Soviet Union notonly relied heavily on queuing, but those with special status, such as party members, had accessto stores denied to the ordinary citizen.

Households differ in size and average age, but these differences are not reflected in the tableabove. Neither is the fact that the amount of time over which income is earned affects the shapeof the Lorenz curve. Larger households tend to earn more than smaller households. People intheir thirties tend to earn more than people in their twenties. Households with four or fivemembers, with more than one person working, and whose working members are between 35 and55 tend to earn more than other households. In a paper published in theAmerican EconomicReview in September of 1975, Morton Paglin concluded that ignoring the influence of age onearnings overstates inequality by 50%. There is also variability from year to year in how muchhouseholds earn. Some people appear poor because they had an unusually bad year, and otherswill seem rich because they had an unusually good year. The shorter the period over which

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income is measured, the more unequal the distribution appears. Thus, if income were measuredover a decade, the distribution would be more equal than any of the yearly distributions.

The other source of problems is in making the initial measurements. The data shown in the tablewere obtained from questionnaires given a sample of 56,000 households. Not all of these

households gave correct answers. The publication containing these data had a lengthy discussionof measurement problems, but when other people use these data in a book or an article or anargument, that lengthy discussion often gets left out (as it does here).1

Despite the measuring problems, it is clear that a system of price rationing will distribute goodsless equally than will alternative systems such as those using queuing or coupons. Many peopleconsider this inequality a major shortcoming of a market economy, and most critics of marketsystems emphasize this characteristic. Defenders of market systems, on the other hand, tend todownplay rationing issues, and instead focus on the ability of a market economy to coordinateinformation and incentives. These are tasks that markets seem to perform very well incomparison to the ways other systems do them.

http://www.jamaica-gleaner.com/gleaner/20071021/business/business1.html