1.3 Module 42: The Market for Labor

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So far in this section we’ve focused on the demand for factors, which determines the quantities demanded of labor, capital, or land by producers as a function of their factor prices. But what about the supply of factors? In this module we focus exclusively on the supply of labor. Labor is the most important factor of production in the modern U.S. economy, accounting for most of factor income. We will look at how labor supply arises from a worker’s decision about time allocation and explore the determination of equilibrium wage and quantity in the labor market.

The Supply of Labor

There are only 24 hours in a day, so to supply labor is to give up leisure, which presents a dilemma of sorts. For this and other reasons, as we’ll see, the labor market looks different from markets for goods and services.

Work versus Leisure

In the labor market, the roles of firms and households are the reverse of what they are in markets for goods and services. A good such as wheat is supplied by firms and demanded by households; labor, though, is demanded by firms and supplied by households. How do people decide how much labor to supply?

As a practical matter, most people have limited control over their work hours: sometimes a worker has little choice but to take a job for a set number of hours per week. However, there is often flexibility to choose among different careers and employment situations that involve varying numbers of work hours. There is a range of part-time and full-time jobs; some are strictly 9:00 a.m. to 5:00 p.m., and others have much longer or shorter work hours. Some people work two jobs; others don’t work at all. And self-employed people have many work-hour options. To simplify our study of labor supply, we will imagine an individual who can choose to work as many or as few hours as he or she likes.

Why wouldn’t such an individual work as many hours as possible? Because workers are human beings, too, and have other uses for their time. An hour spent on the job is an hour not spent on other, presumably more pleasant, activities. So the decision about how much labor to supply involves making a decision about time allocation—how many hours to spend on different activities.

By working, people earn income that they can use to buy goods. The more hours an individual works, the more goods he or she can afford to buy. But this increased purchasing power comes at the expense of a reduction in leisure, the time spent not working. (Leisure doesn’t necessarily mean time goofing off. It could mean time spent with one’s family, pursuing hobbies, exercising, and so on.) And though purchased goods yield utility, so does leisure. Indeed, we can think of leisure itself as a normal good, which most people would like to consume more of as their incomes increase.

How does a rational individual decide how much leisure to consume? By making a marginal comparison, of course. In analyzing consumer choice, we asked how a utility-maximizing consumer uses a marginal dollar. In analyzing labor supply, we ask how an individual uses a marginal hour.

Every worker faces a trade-off between leisure and work.

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Consider Clive, an individual who likes both leisure and the goods money can buy. Suppose that his wage rate is $10 per hour. In deciding how many hours he wants to work, he must compare the marginal utility of an additional hour of leisure with the additional utility he gets from $10 worth of goods. If $10 worth of goods adds more to his total utility than an additional hour of leisure, he can increase his total utility by giving up an hour of leisure in order to work an additional hour. If an extra hour of leisure adds more to his total utility than $10 worth of goods, he can increase his total utility by working one fewer hour in order to gain an hour of leisure.

At Clive’s optimal level of labor supply, then, the marginal utility he receives from one hour of leisure is equal to the marginal utility he receives from the goods that his hourly wage can purchase. This is very similar to the optimal consumption rule we encountered previously, except that it is a rule about time rather than money.

Our next step is to ask how Clive’s decision about time allocation is affected when his wage rate changes.

Wages and Labor Supply

Suppose that Clive’s wage rate doubles, from $10 to $20 per hour. How will he change his time allocation?

You could argue that Clive will work longer hours because his incentive to work has increased: by giving up an hour of leisure, he can now gain twice as much money as before. But you could equally well argue that he will work less because he doesn’t need to work as many hours to generate the income required to pay for the goods he wants.

As these opposing arguments suggest, the quantity of labor Clive supplies can either rise or fall when his wage rate rises. To understand why, let’s recall the distinction between substitution effects and income effects. We have seen that a price change affects consumer choice in two ways: by changing the opportunity cost of a good in terms of other goods (the substitution effect) and by making the consumer richer or poorer (the income effect).

Now think about how a rise in Clive’s wage rate affects his demand for leisure. The opportunity cost of leisure—the amount of money he gives up by taking an hour off instead of working—rises. That substitution effect gives him an incentive, other things equal, to consume less leisure and work longer hours. Conversely, a higher wage rate makes Clive richer—and this income effect leads him, other things equal, to want to consume more leisure and supply less labor because leisure is a normal good.

So in the case of labor supply, the substitution effect and the income effect work in opposite directions. If the substitution effect is so powerful that it dominates the income effect, an increase in Clive’s wage rate leads him to supply more hours of labor.

If the income effect is so powerful that it dominates the substitution effect, an increase in the wage rate leads him to supply fewer hours of labor.

We see, then, that the individual labor supply curve—the relationship between the wage rate and the number of hours of labor supplied by an individual worker—does not necessarily slope upward. If the income effect dominates, a higher wage rate will reduce the quantity of labor supplied.

Figure 42-1 illustrates the two possibilities for labor supply. If the substitution effect dominates the income effect, the individual labor supply curve slopes upward; panel (a) shows an increase in the wage rate from $10 to $20 per hour leading to a rise in the number of hours worked from 40 to 50. However, if the income effect dominates, the quantity of labor supplied goes down when the wage rate increases. Panel (b) shows the same rise in the wage rate leading to a fall in the number of hours worked from 40 to 30.

When the substitution effect of a wage increase dominates the income effect, the individual labor supply curve slopes upward, as in panel (a). Here a rise in the wage rate from $10 to $20 per hour increases the number of hours worked from 40 to 50. But when the income effect of a wage increase dominates the substitution effect, the individual labor supply curve slopes downward, as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30. The individual labor supply curve shows how the quantity of labor supplied by an individual depends on that individual’s wage rate.

Economists refer to an individual labor supply curve that contains both upward-sloping and downward-sloping segments as a “backward-bending labor supply curve.” At lower wage rates, the substitution effect dominates the income effect. At higher wage rates, the income effect eventually dominates the substitution effect.

Is a backward-bending labor supply curve a real possibility? Yes: many labor economists believe that income effects on the supply of labor may be somewhat stronger than substitution effects at high wage rates.

The most compelling piece of evidence for this belief comes from Americans’ increasing consumption of leisure over the past century. At the end of the nineteenth century, wages adjusted for inflation were only about one-eighth what they are today; the typical work week was 70 hours, and very few workers retired at age 65. Today the typical work week is less than 40 hours, and most people retire at age 65 or earlier. So it seems that Americans have chosen to take advantage of higher wages in part by consuming more leisure.

Shifts of the Labor Supply Curve

Now that we have examined how income and substitution effects shape the individual labor supply curve, we can turn to the market labor supply curve. In any labor market, the market supply curve is the horizontal sum of the individual labor supply curves of all workers in that market. A change in any factor other than the wage that alters workers’ willingness to supply labor causes a shift of the labor supply curve. A variety of factors can lead to such shifts, including changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth.

When factors other than wages alter the willingness of workers to supply labor, the labor supply curve will shift.

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Changes in Preferences and Social NormsChanges in preferences and social norms can lead workers to increase or decrease their willingness to work at any given wage. A striking example of this phenomenon is the large increase in the number of employed women—particularly married, employed women—that has occurred in the United States since the 1960s. Until that time, women who could afford to largely avoided working outside the home.

Changes in preferences and norms in post−World War II America (helped along by the invention of labor-saving home appliances such as washing machines, the trend for more people to live in cities, and higher female education levels) have induced large numbers of American women to join the workforce—a phenomenon often observed in other countries that experience similar social and technological changes.

Changes in PopulationChanges in the population size generally lead to shifts of the labor supply curve. A larger population tends to shift the labor supply curve right-ward as more workers are available at any given wage; a smaller population tends to shift the labor supply curve leftward due to fewer available workers. Currently the size of the U.S. labor force grows by approximately 1% per year, a result of immigration and, in comparison to other developed countries, a relatively high birth rate, shifting the U.S. labor supply curve to the right. Of course, from 2008 to 2010, due to the Great Recession and despite continued population growth, the size of the labor force began to shrink as workers disillusioned by bad job prospects left the labor force. The result: during that time, the U.S. labor supply curve shifted leftward.

Changes in OpportunitiesAt one time, teaching was the only occupation considered suitable for well-educated women. However, as opportunities in other professions opened up to women starting in the 1960s, many women left teaching and chose other careers. This generated a leftward shift of the supply curve for teachers, reflecting a fall in the willingness to work at any given wage and forcing school districts to pay more to maintain an adequate teaching staff.

These events illustrate a general result: when superior alternatives arise for workers in another labor market, the supply curve in the original labor market shifts leftward as workers move to the new opportunities.

Similarly, when opportunities diminish in one labor market—say, layoffs in the manufacturing industry due to increased foreign competition—the supply in alternative labor markets increases as workers move to these other markets.

Changes in WealthA person whose wealth increases will buy more normal goods, including leisure. So when a class of workers experiences a general increase in wealth—say, due to a stock market boom—the income effect from the wealth increase will shift the labor supply curve associated with those workers leftward as workers consume more leisure and work less. Note that the income effect caused by a change in wealth shifts the labor supply curve, but the income effect from a wage rate increase—as we discussed in the case of the individual labor supply curve—is a movement along the labor supply curve.

!world_eia!THE OVERWORKED AMERICAN?

Americans today may work less than they did a hundred years ago, but they still work more than workers in any other industrialized country.

Figure 42-2 compares average annual hours worked in the United States with those worked in other industrialized countries. The differences result from a combination of Americans’ longer workweeks and shorter vacations. For example, the great majority of full-time American workers put in at least 40 hours per week. Until recently, however, a government mandate limited most French workers to a 35-hour workweek; collective bargaining has achieved a similar reduction in the workweek for many German workers.

Source: OECD.

In 2012, American workers got, on average, ten paid vacation days, but 23% of American workers got none at all. In contrast, German workers are guaranteed six weeks of paid vacation a year. Also, American workers use fewer of the vacation days they are entitled to than do workers in other industrialized countries. A 2011 survey found that only 57% of American workers use all the vacation days they are entitled to, compared to 89% in France.

Why do Americans work so much more than others? Unlike their counterparts in other industrialized countries, Americans are not legally entitled to paid vacation days; as a result, the average American worker gets fewer of them. Moreover, anecdotal evidence suggests that during the recent recession, with its high rates of unemployment, American workers became more reluctant to use the vacation days they were entitled to.

Equilibrium in the Labor Market

Now that we have discussed the labor supply curve, we can use the supply and demand curves for labor to determine the equilibrium wage and level of employment in the labor market.

Figure 42-3 illustrates the labor market as a whole. The market labor demand curve, like the market demand curve for a good, is the horizontal sum of all the individual labor demand curves of all the firms that hire labor. And recall that a price-taking firm’s labor demand curve is the same as its value of the marginal product of labor curve.

The market labor demand curve is the horizontal sum of the individual labor demand curves of all producers. Here the equilibrium wage rate is W*, the equilibrium employment level is L*, and every producer hires labor up to the point at which VMPL = W*. So labor is paid its equilibrium value of the marginal product, that is, the value of the marginal product of the last worker hired in the labor market as a whole.

The equilibrium wage rate is the wage rate at which the quantity of labor supplied is equal to the quantity of labor demanded. In Figure 42-3, this leads to an equilibrium wage rate of W* and the corresponding equilibrium employment level of L*. (The equilibrium wage rate is also known as the market wage rate.)

When the Product Market Is Not Perfectly Competitive

When the product market is perfectly competitive, the wage rate is equal to the value of the marginal product of labor at equilibrium. In other market structures this is not the case. For example, in a monopoly, the demand curve for the product faced by the mon opolist slopes downward. This means that to sell an additional unit of output, the monopolist must lower the price. As a result, the additional revenue received from selling one more unit for a monopolist is not simply the price like it was for a perfect competitor. It is less than the price by the amount of the price effect explained previously—the decreased revenue on units that could have been sold at a higher price if the price hadn’t been lowered to sell another unit. How does this affect hiring? To determine its demand for workers, the monopolist must multiply the marginal product of labor by the marginal revenue received from selling the additional output. This is called the marginal revenue product of labor or MRPL.

Table 42-1 shows the calculation of a firm’s marginal revenue product of labor.

For a perfectly competitive firm, marginal revenue equals price, so VMPL and MRPL are equivalent. The two concepts measure the same thing: the value to the firm of hiring an additional worker. The term MRPL is a more general term that applies to firms in both perfect competition and imperfect competition. The general rule is that a profit-maximizing firm in an imperfectly competitive product market employs each factor of production up to the point at which the marginal revenue product of the last unit of the factor employed is equal to that factor’s cost.

In the case of a firm operating in an imperfectly competitive product market, the demand curve for a factor is the marginal revenue product curve, as shown in Figure 42-4.

A firm’s labor demand curve is the marginal revenue product of labor curve, which differs from the value of the marginal product of labor curve when there is imperfect competition in the product market (as with a monopoly, for example). With perfect competition, the marginal revenue product of labor (MPL × MR) and the value of the marginal product of labor (MPL × P) are the same because MR = P.

When the Labor Market Is Not Perfectly Competitive

There are also important differences when considering the labor demand curve for a firm in an imperfectly competitive labor market rather than in a perfectly competitive labor market. With perfect competition in the labor market, each firm is so small that it can hire as much labor as it wants at the market wage. The firm’s hiring decision will not affect the market. In contrast, a firm in an imperfectly competitive labor market is large enough to affect the market wage. A labor market in which there is only one firm hiring labor is called a monopsony. A monopsonist is the single buyer of a factor. Perhaps you’ve seen a small town where one firm, such as a meatpacking company or a lumber mill, hires most of the labor—that’s an example of a monopsony. Since the firm already hires most of the available labor in the town, if it wants to hire more workers, it has to offer higher wages to attract them.

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