Econ 2

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Econ 2

• Market Imperfections (Midterm 1, Ch5, 12, 13))
• Market Failure and Government (Midterm 2, Ch14,
  15, 16))

• Factor Market (Ch17), Inequality (Ch18) and
  Uncertainty (Ch19)

• International Trade (Ch20)

Reminder The final is cumulative!
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Factors of Production

• Definition factors of production are the inputs
  that a firm requires in order to produce its
  output.
• Factors of production are traded in markets where
  their prices and quantities are determined by the
  market forces of demand and supply
• The demand for a factor of production is called a
  derived demand because it is derived from the
  demand for the goods and services produced by the
  factor

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Factors of Production Labor
Factor price of labor is the wage rate
4
Factors of Production Capital
Capital markets are the channels through which
firms obtain financial resources to buy physical
capital. The markets in which each item of
physical capital is traded are NOT the capital
market, they are goods markets. Interest rate is
the price of (financial) capital, it is the
opportunity cost of the funds used to finance
capital.
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Factors of Production Land
In economics, land is what in everyday language
we call natural resources, it includes land and
other raw materials. Factor price of land is the
rental rate.
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Factors of Production entrepreneurship
Need entrepreneurs put things together! Factor
price of entrepreneurship is the profit rate.
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Factor Prices and Incomes

• The factor income earned by the owner of a factor
  of production
• PF ?QF
• A change in demand or supply changes
• PF
• QF
• factor income

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The Market for Labor How much labor to hire?
MR P in this case because the firm is assumed
to operate in a perfectly competitive market, so
it is a price taker
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Diminishing marginal product of labor
Output (Q)
Production Function
Notice that the production function becomes
flatter as the number of workers rises, this
property is called the diminishing marginal
product
Labor
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• Again, we have seen that there is diminishing
  returns to labor (diminishing MPL )
• So the value of marginal product, or the marginal
  revenue product (MRPLMPL ? P)
• diminishes as workers increase
• Lets consider the firms decision graphically

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Marginal revenue product of labor wage (/hr)
MRPL curve is also the demand for labor curve
The curve slops downward because of diminishing
marginal product
To max profit, the firm hires workers up to the
point where W P? MPL MRPL
market wage W
Q of workers
Profit maximizing quantity of labor
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Equivalence of the Two Conditions for Firms
Profit Maximization

• Employ the quantity of labor at which
• MRPW (1)
• Produce the quantity of output at which
• MR MC (2)
• These two conditions are equivalent.
• To see that (1) implies (2)
• Rewrite (1) MRP MP ? MR W
• Divide both sides by MP MR W/MP
• But W/MP MC (the wage rate divided by the
  marginal product is the marginal cost)
• So MR MC (2)

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Shifts in Labor Demand

• Changes in the price of the firms output
• - The higher the price of the firms output, the
  greater is the firms demand for labor, the
  demand for labor curve shifts rightward

Wage
Labor
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• Changes in other factor prices
• A factor that is a substitute for labor
• e.g. gets cheaper, demand for
  factory worker decreases, demand curve shifts
  leftward
• A factor that is a complement of labor
• e.g. gets cheaper, demand for highly
  skilled worker increases, demand curve shifts
  rightward

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• Technology and capital that changes the marginal
  product of labor
• New technologies and capital are substitutes for
  some types of labor and decrease the demand for
  labor, they are complements of other kinds and
  increases the demand for labor

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Market Demand for labor

• The market demand for labor is obtained by adding
  together the quantities of labor demanded by all
  firms at each wage rate.

17
The supply of labor

• People choose between work and leisure
• The opportunity cost of leisure is the wage rate
• Higher wage rate induces more work substitution
  effect
• Higher wage rate means higher income, and higher
  income induces more consumption of normal goods,
  for which leisure is an example so higher wage
  rate results in less work income effect

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Backward-Bending Supply of Labor Curve
At low wage rates, the substitution effect might
dominate, so as the wage rate rises, people
supply more labor. At high wage rates, the income
effect might dominate, so as the wage rate rises,
people supply less labor. The market supply
curve has a long upward-sloping section but it
may eventually bend backward.
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Shifts in labor supply

• The key factors that change the supply of labor
  are
• Increases in adult population
• Technological change and capital accumulation
• in home production

20
Labor Market Equilibrium Trends

• Overtime, increases in population means more
  people looking for jobs.

21
Note that the aggregate labor supply curves here
are assumed to be vertical for the purpose of
simple illustration If labor demand were fixed,
that would mean falling wages every year
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But real compensation per worker has increased
almost every year
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Implication Labor demand curve must have also
shifted every year by more than the labor supply
curve
What accounts for shifts in labor demand? Most
likely gains in labor productivity
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• Introduced factors of production, factor prices,
  factor income
• Examined firms decision of how much labor to
  hire set W MRPL
• MRP curve is the demand curve
• Equivalence of the Two conditions for profit
  maximization shows when the firm employs the
  profit max. quantity of labor, it produces the
  profit max. quantity of output
• What shifts the demand for labor curve
• Supply of labor individuals decision to
  allocate work and leisure
• How does higher wage rate affect labor supply?
  Substitution effect versus income effect
• The possibility of a backward bending labor
  supply curve
• What shifts the labor supply curve
• Labor market trends in the U.S., both the demand
  for labor and the supply of labor have increased
  over time. For most workers, the demand has
  increased more than the supply, so their wage
  rate has risen and the quantity of employment has
  increased too

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• So far we have assumed perfect competition in the
  labor market
• Workers are equally good, have the same
  productivity
• No labor unions
• There are a large number of firms in a industry
• Workers dont care which firms to work at
• Agents in the market have perfect information
• These imply that all firms in this industry
  must pay the same wage
• Now we will look at deviations from these
  assumptions and try to explain the differences in
  earnings.

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Bureau of Labor StatisticsOccupational Outlook
Handbook2008-09 Edition
27
Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity
• 2. Unions
• 3. Monopsony
• 4. Compensating wage differentials
• 5. Efficiency wages

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1 Why productivities differ?

• Factors that affect the value of a workers
  marginal product education, training,
  experience, health, energy, intelligence, work
  habits, trustworthiness, and initiative, etc.
• A worker can raise his or her marginal product,
  henceforth wage, by investing in education and
  training.
• Human capital is the accumulation of investments
  in people, such as education and training.
• Like all forms of capital, education represents
  an expenditure at one point in time to raise
  productivity in the future. An investment in
  education is tied to a specific person, and this
  linkage is what makes it human capital.
• Human Capital Theory of wage determination says a
  workers wage will be proportional to his or her
  stock of human capital

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Why are you in college?

• Education can raise wages through enhancing
  productivity College graduates in the U.S. earn
  about 65 more than those with only high school
  diploma
• Firms are willing to pay more for the highly
  educated because highly educated workers have
  higher marginal products
• Workers are willing to pay the cost of becoming
  educated only if there is a reward for doing so

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Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity
• 2. Unions
• 3. Monopsony
• 4. Compensating wage differentials
• 5. Efficiency wages

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2. Labor Unions

• Labor Union A group of workers who bargain
  collectively with employers for better wages and
  working conditions
• How does the unionization of a labor market
  affect wages?

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Unions Objectives and Constraints

• Objectives
• 1. Increase compensation
• 2. Improve working conditions
• 3. Expand job opportunities
• Constraints
• 1. Limited ability to restrict nonunion labor
  from replacing union labor, which depends upon
  the fraction of work force controlled by the
  union.
• 2. Limited ability to retain union jobs in
  the face of higher wages and benefits, which
  depends upon the elasticity of demand for the
  union labor

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A Union Enters a Competitive Labor Market
Wage rate (/hour)
S (union)
S (no union)
Unions try to restrict the supply of union labor
and raise the wage rate
D (union)
Unions may also try to increase the demand for
labor
D (no union)
Labor (hours per day)
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Unions try to increase the demand for union labor
by

• Increasing the marginal product of union members
• Encouraging import restrictions
• Supporting minimum wage laws
• Support immigration restrictions
• Increase demand for the good produced

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Why join a union?

• A union restricts the supply of union members,
  this increases the supply of labor in nonunion
  markets. This increase in the supply of labor in
  nonunion markets lowers the wage rate in those
  markets and further widens the gap between union
  and nonunion wages.
• The scale of Union-Nonunion wage gap the
  evidence suggests that after allowing for skill
  differences, the union-nonunion wage gap lies
  between 10 and 25.
• e.g. Unionized airline pilots earn about 25
  more than nonunion pilots with the same level of
  skill.

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Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity
• 2. Unions
• 3. Monopsony
• 4. Compensating wage differentials
• 5. Efficiency wages

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3. Monopsony

• Monopoly Only one seller in the market
• Monopsony Only one buyer in the market
• Examples of monopsony
• coal mining town in which coal company hires
  majority of the people who work
• In some communities, Wal-Mart is the main
  employer of sales clerks
• Because a monopsony controls the labor market, it
  has the market power to set the market wage rate.
  It uses this market power to lower the wage rate
  below the level paid by firms in a competitive
  market.

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When a monopsony encounters a labor union

• Sometimes both the firm and the employees have
  market power (in labor markets). Suppose that a
  union operates in a monopsony labor market, the
  situation is called bilateral monopoly.
• In bilateral monopoly, the wage rate is
  determined by bargaining.
• The outcome of bargaining depends on the costs
  that each party can inflict on the other. The
  outcome of this situation may favor either the
  union or the firm.

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Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity
• 2. Unions
• 3. Monopsony
• 4. Compensating wage differentials
• 5. Efficiency wages

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4. Compensating Wage Differentials

• Wage is only one of many job attributes that the
  worker takes into account when deciding whether
  to take the job
• The nonmonetary aspects indoor versus outdoor
  safe versus dangerous or risky, clean versus
  dirty,
• The idea is bad jobs will tend to have higher
  equilibrium wages than good jobs to compensate
  the labor for enduring its badness or
  undesirableness.
• e.g. Taxi and limousine service 10.62/ hour
• Garbage collector
  14/hour
• Compensating differential refers to a difference
  in wages that arise from nonmonetary
  characteristics of different jobs.

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Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity
• 2. Unions
• 3. Monopsony
• 4. Compensating wage differentials
• 5. Efficiency wages

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5. Efficiency Wages

• In a perfectly competitive labor market, firms
  and workers are well informed so pay the going
  competitive market wage rate.
• In some labor markets, the employer is not able
  to observe a workers marginal product. It is
  costly to monitor all the actions of every
  worker. So workers may work hard or shirk.
• So a firm can pay a wage rate above the
  competitive equilibrium wage rate with the aim of
  attracting the most productive workers. We call
  this wage the efficiency wage.

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5. Efficiency Wages

• With efficiency wage (paid above the competitive
  market wage rate), the threat of being fired for
  shirking has some force.
• A fired worker can expect to find another job but
  only at a lower rate, i.e., at the market
  equilibrium wage rate that is lower than the
  efficiency wage.
• So the worker now has an incentive not to shirk.
  And hardworking workers will be more likely to
  want to work for the firm.
• Firm must decide how much more than the
  competitive wage to pay by comparing the marginal
  improvement in productivity and the marginal cost
  of higher wage rate.

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Explanations for Differences in Earnings

• Different explanations for difference in earnings
  are
• 1. Differences in productivity College-High
  school wage gap
• 2. Unions Union-Nonunion wage gap
• 3. Monopsony Market power in the hands of the
  employer
• 4. Compensating wage differentials nonmonetary
  job attributes matter
• 5. Efficiency wages prevent worker from shirking

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Ability, Effort, and Opportunity

• When labor economists study wages, they find that
  years of schooling, experience, age, job
  characteristics, all these measurable variables
  affect a workers wage as theory predicts,
  however, they account for less than 50 of the
  variation in wages. Because so much of the
  variation in wages is left unexplained, omitted
  variables, including ability, effort, and
  opportunity, can play an important role in
  determining wage rate.