13.4 The Labor Market in the Long Run

Our labor market analysis up to this point has been for the short run when the firm’s level of capital is fixed. Now we look at what happens when the firm can change its capital level.

Earlier we learned that changes in the amount of capital a firm has alter the marginal product of labor MPL and thus shift the short-run labor demand curve. As we saw in Chapter 6, an increase in capital raises MPL, increases the quantity of labor demanded at each wage, and shifts out the firm’s short-run labor demand curve. Decreases in capital lower MPL and shift the firm’s short-run labor demand curve in.

Suppose that there is a permanent drop in the market equilibrium wage, as shown in Figure 13.8. The firm initially has a short-run demand for labor given by MRPL1. Given that the firm’s MRPL equals the initial wage W1 at point a, the firm hires the quantity of labor l1. In the short run, if the wage drops to W2 and the firm’s stock of capital is fixed, the firm will hire more labor until MRPL1 equals the lower wage, at point b, resulting in the quantity of labor l2.

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Figure 13.8: FIGURE 13.8 Short-Run and Long-Run Labor Demand
Figure 13.8: A firm facing a market wage W1 and having a short-run demand for labor given by MRPL1 initially hires labor quantity l1 (point a). The short-run effect of a permanent drop in the market equilibrium wage from W1 to W2 will cause the firm to hire more labor until MRPL1 equals W2. This is labor quantity l2 (point b). In the long run, the increase in labor hired to l2 raises the firm’s marginal product of capital, which leads the firm to purchase more capital and, in turn, raises the firm’s marginal revenue product of labor. This shifts out the firm’s short-run labor demand curve to MRPL2, and the firm hires additional labor until W2 = MRPL2. This is labor quantity l3 (point c). The long-run labor demand curve, ID, runs through points a and c.

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FREAKONOMICS

Competition in the Market for Economists

Ahttp://www.bls.gov/news.release/history/ocwage_12202000.txt

Bhttp://www.bls.gov/news.release/pfd/ocwage.pdf

Fifteen years ago, the average salary for academic economists was $58,730. The comparable number for historians was only a little bit lower—about $50,800.A Nowadays, an economics teacher can expect to earn $102,120 per year on average. That is an increase of almost 75%—great news for budding economists. Time has not been as kind to historians. Their average salaries have only increased to $73,720 a year.B The wages of historians have barely kept up with inflation.

A http://www.bls.gov/news.release/history/ocwage_12202000.txt

B http://www.bls.gov/news.release/pdf/ocwage.pdf

Chttps://labor.ny.gov/stats/ins.asp

What explains the divergence in wages between academic economists and historians? Ironically, it likely has little or nothing to do with academics. Rather, the reasons for economists’ rising salaries are two changes that took place on Wall Street. The first change is that Wall Street salaries, which were already high, have skyrocketed over the last fifteen years. According to the U.S. Department of Labor, employees in “Securities, Commodity Contracts, and Other Financial Investments and Related Activities” working in New York City earned an average pay of $384,344 in 2014.C The second change is that, over time, the set of skills that one learns when getting an economics degree have become more and more highly prized. Quantitative models, economic analysis, and the study of behavioral anomalies have become the norm in the finance industry. Sadly for historians, Wall Street has not (yet) come to appreciate the value of a good historical narrative.

C https://labor.ny.gov/stats/ins.asp

So even though the day-to-day activities of an academic economist (teaching, doing research) are very different than the daily activities of Wall Street financiers, the very specialized talents that an economics degree teaches are an input to both jobs. Thus, universities seeking economics professors compete not just against other universities for talent, but in a broader labor market that includes Wall Street, management consulting, and other jobs that might be attractive to economists. Universities haven’t raised salaries for economics professors out of the goodness of their hearts, but, rather, because markets haven’t given them a choice if they want to attract the best talent.

Just because universities compete with Wall Street for economists doesn’t mean, however, that they need to match Wall Street salaries dollar for dollar. For many people, being a professor is a much more attractive job (fewer hours, more freedom, less stress, the joy of interacting with students, among other perks). Thus, all else equal, most economics PhDs are willing to take a large (but not infinitely large) salary hit to go into academics.

Dhttps://apir.wisc.edu/degrees/BADegrees20052014.pdf

Ehttp://www.brown.edu/about/administration/institutional-research/factbook/degrees-and-completions

The good news for you—should you choose to major in economics—is that all the evidence suggests that the market rewards for economists will only grow. Firms are increasingly coming to appreciate the value and importance of “Big Data” and are desperate to find people capable of teasing the insights from these data. “Data scientist” is one of the fastest growing job categories in America today, and many of these jobs are going to economists.

And if you need any additional evidence of the power of economics, you need look no further than the trends in college major choices. At the University of Wisconsin-Madison, for instance, 333 undergraduate students graduated with a major in economics in 2005. By 2014, that number had increased to 549.D As for history majors, there were 354 history graduates in 2005 and only 238 in 2014. At Brown, this trend has been particularly striking—in 2005, only 4% of students completed a concentration in economics; but by 2014, 10% of students had done so. Meanwhile, the percentage of completed history concentrations fell from about 7.5% in 2005 to 4% in 2014.E Just as economics would predict, when something becomes more valuable, people want more of it.

D https://apir.wisc.edu/degrees/BADegrees20052014.pdf

E http://www.brown.edu/about/administration/institutional-research/factbook/degrees-and-completions

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In the long run, however, this is not the total effect of the lower wage. The increase in labor hired to l2 also raises the firm’s marginal product of capital because, as we saw in Chapter 6, for most production functions, having more of one input raises the marginal product of the other. The increase in the marginal product of capital gives the firm an incentive to purchase more capital. When it does, the additional capital, in turn, raises the firm’s marginal product of labor, and thus its marginal revenue product of labor. The increased MRPL increases the amount of labor the firm demands at each wage and shifts out the firm’s short-run labor demand curve to MRPL2, the marginal revenue product curve of the firm at its new, higher capital level. Because the wage W2 and the firm’s new short-run labor demand curve MRPL2 are equal at point c, the firm hires l3.

Step back for a second and think about the total effect of the decreased wage on the firm’s quantity of labor demanded. At wage W1, the firm demanded the quantity of labor l1. When the wage fell to W2, once it had enough time to adjust its amount of capital, the firm ended up demanding quantity l3. Therefore, the curve running through points a and c in Figure 13.8, lD, is the firm’s long-run labor demand curve. It shows the firm’s desired hiring at any wage level once the firm is able to fully adjust its capital inputs. The long-run labor demand curve is the firm’s quantity of labor demanded when the time horizon is long enough that the firm’s capital inputs are completely flexible.

The long-run labor demand curve is flatter than the short-run curve because in the long run, the quantity of labor demanded increases as the quantity of capital increases. This raises labor’s marginal revenue product relative to what it would be had capital remained constant, counteracting some of the drop in the MRPL in the short run. At a practical level, firms’ decisions about hiring labor are more responsive to wage changes in the long run than in the short run. Decreases in wages boost hiring more than they would in the short run, and increases in wages have larger negative effects on hiring.