Distortions

1
Distortions
W(eme) W(emr) Wage

• Labor demand curve maps qty. of labor demanded to
  employer wage
• Labor supply curve maps qty. of labor supplied to
  employee wage
• When employee wage employer wage, two curves
  share a vertical axis, be plotted together.

L(S) to W(eme)
L(D) to W(emr)
2
Distortions
Which wage?

• When employee wage does not equal employer wage,
  there is a distortion in the labor market.
• What employers pay to acquire labor does not
  equal what employees get for supplying labor.
• Labor supply and demand curves do not share an
  axis, cannot be plotted together.

L(S) to W(eme)
L(D) to W(emr)
3
Distortions
Which wage?

• Problem fixed by drafting new labor supply curve
  that maps quantity of labor supplied to employer
  wage.
• Find out how to convert employer wage to employer
  wage
• Convert employee wages on labor supply curve to
  employer wages
• Use converted labor supply curve to find
  equilibrium

L(S) to W(eme)
L(D) to W(emr)
4
Distortions
L(S) to W(emr)
Which wage?

• Ex. A 10 wage tax
• Employer wage about 10 above employee wage.
• Employee wages can be converted to employer wages
  by simply moving up the graph by about 10
• Labor supply curve that maps employee wage can be
  converted to one that maps employer wage by
  moving it up graph by 10

L(S) to W(eme)
10
L(D) to W(emr)
5
Distortions
L(S) to W(emr)
Employer wage

• Ex. A 10 wage tax
• We now have curves that tell us what L(S) and
  L(D) is at each employer wage.
• We know the employer wage where L(S) L(D)
  equilibrium employer wage.
• Since employer wage about 10 greater than
  employee wage, equilibrium employee wage about
  10 less than equilibrium employer wage.

L(S) to W(eme)
10
W(emr)
10
W(eme)
L(D) to W(emr)
L(S) L(D) L
6
Distortions
L(S) to W(emr)
Employer wage

• Ex. A 10 wage tax
• Employer surplus (blue) equals the area above the
  equilibrium employer wage and below the labor
  demand curve.
• Employee surplus (green) equals the area below
  the equilibrium employee wage and above the old,
  employee-wage labor supply curve.

L(S) to W(eme)
10
W(emr)
10
W(eme)
L(D) to W(emr)
L(S) L(D) L
7
Distortions
L(S) to W(emr)
Employer wage

• Without tax
• Find equilibrium using old L(S), L(D) curves
• Equilibrium employer wage is lower
• Equilibrium employee wage is higher
• Equilibrium quantity of labor transacted is
  greater
• Employer surplus greater
• Employee surplus greater

L(S) to W(eme)
W(emr)
W(no tax)
W(eme)
L(D) to W(emr)
L L(no tax)
8
Distortions
L(S) to W(emr)
Employer wage

• Ex. A 10 wage tax
• Total surplus is lower because of tax
• Some of lost total surplus made up by government
  revenue from tax collections (yellow)
• Some of lost total surplus is not (red), called
  dead weight loss

L(S) to W(eme)
W(emr)
W(no tax)
W(eme)
L(D) to W(emr)
L L(no tax)
9
Distortions
L(S) to W(emr)
Employer wage

• Ex. A 10 wage tax
• Total surplus is lower because of tax
• Some of lost total surplus made up by government
  revenue from tax collections (yellow)
• Some of lost total surplus is not (red), called
  dead weight loss

L(S) to W(eme)
W(emr)
W(no tax)
W(eme)
L(D) to W(emr)
L L(no tax)
10
The Elasticity of Labor Demand
W(emp)

• Elasticity of labor demand measures sensitivity
  of qty. of labor demanded to employer wage.
• If employers reduce hiring by a lot when wage
  they must pay increases, then labor demand is
  elastic.
• If employers reduce hiring by only a little, then
  labor demand is inelastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
11
The Elasticity of Labor Demand
W(emp)

• The larger the scale and substitution effects,
  the greater the elasticity
• If increase in wage results in large increase in
  firms production costs, then firms will reduce
  hiring by a lot.
• If increase in wage results in firms substituting
  other kinds of labor or capital to do same work,
  then firms will reduce hiring by a lot.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
12
The Hicks-Marshall Conditions
W(emp)

• A famous result about the determinants of the
  elasticity of labor demand are the Hicks-Marshall
  conditions of derived demand.
• Alfred Marshall, Principles of Economics (1890)
• John Hicks, The Theory of Wages (1943)

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
13
The Hicks-Marshall Conditions
W(emp)

• 1. The more substitutable the labor, the greater
  the elasticity of labor demand.
• If employee wage increases, firms have option of
  hiring substitute kinds of labor, capital, etc.
• The easier substitution will be, the more likely
  firms will do it, the greater the reduction in
  firms hiring.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
14
The Hicks-Marshall Conditions
W(emp)

• Ex. Suppose the wages of union workers increase.
• Employers may say The union guys are great,
  theres no substitute for them, Ill still hire
  them, theyre worth it. L(D) is inelastic.
• Or Why should I pay that much more for union
  guys? The nonunion guys are just as good. Im
  switching to them. L(D) is elastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
15
The Hicks-Marshall Conditions
W(emp)

• 2. The greater the supply elasticity of
  substitutes, the greater the elasticity of labor
  demand.
• Increase in wage increases demand for substitutes
• Increase in demand bids up wage/price of
  substitutes, reduces substitutes appeal
• Greater substitute supply elasticity, smaller the
  effect

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
16
The Hicks-Marshall Conditions
W(emp)

• 2. Ex. Suppose the wages of union workers
  increase.
• Firms subst. nonunioners
• Demand for nonunion workers increases.
• Small elasticity of labor supply of nonunion
  workers increase in demand vastly bids up
  nonunion wage
• Nonunion less appealing, union workers still
  hired, L(D) inelastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
17
The Hicks-Marshall Conditions
W(emp)

• 2. Ex. Suppose the wages of union workers
  increase.
• Firms subst. nonunioners
• Demand for nonunion workers increases.
• Large elasticity of labor supply of nonunion
  workers increase in demand hardly bids up
  nonunion wage
• Nonunion still appealing substitute, union
  workers get cut, L(D) elastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
18
The Hicks-Marshall Conditions
W(emp)

• 3. The greater the share of firms total costs
  paid to kind of labor, the greater elasticity of
  labor demand.
• Greater the share of costs, greater the increase
  in firms total costs caused by wage increase.
• Greater the increase in prices, greater decrease
  in sales, greater decrease in need for all kinds
  of labor.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
19
The Hicks-Marshall Conditions
W(emp)

• 3. Ex. Suppose the wages of union workers
  increase.
• If cost of hiring union workers only 1 of total
  cost, then firms total production cost increases
  by only a little.
• Firms increase their prices by only a little,
  lose few customers, barely decrease production,
  let few union workers go. L(D) inelastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
20
The Hicks-Marshall Conditions
W(emp)

• 3. Ex. Suppose the wages of union workers
  increase.
• If cost of hiring union workers is 100 of total
  cost, then firms total production cost increases
  by a lot.
• Firms increase their prices a lot, lose many
  customers, seriously cut production, let many
  union workers go. L(D) elastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
21
The Hicks-Marshall Conditions
W(emp)

• 4. The greater the product demand elasticity, the
  greater the elasticity of labor demand.
• Increase in wage increases firms total costs,
  prices
• Greater product demand elasticity, greater sales
  drop caused by price increase
• Greater sales drop, greater decrease in need for
  labor.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
22
The Hicks-Marshall Conditions
W(emp)

• 4. Ex. Suppose the wages of union workers
  increase.
• Increase in wage increases firms total costs,
  prices
• If product demand elasticity is slight, then
  people gladly pay higher prices, do not buy fewer
  goods.
• Firms still need as many workers as before, do
  not cut workers. L(D) inelastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
23
The Hicks-Marshall Conditions
W(emp)

• 4. Ex. Suppose the wages of union workers
  increase.
• Increase in wage increases firms total costs,
  prices
• If product demand elasticity is great, then
  people unwilling to pay higher prices, buy fewer
  goods.
• Firms dont need as many workers as before, cut
  workers. L(D) elastic.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic
24
The Hicks-Marshall Conditions
W(emp)

• Conditions 1-2 deal with substitution effect, 3-4
  deal with scale effect.
• Conditions 1, 2, and 4 theoretically hold under
  standard economic assumptions, 3 requires more
  restrictive assumptions.

L(D)
L(D)
L(D) elastic
W(emp)
L(D)
L(D)
L(D) inelastic