Lecture Notes

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Lecture Notes ECON 437/837 ECONOMIC
COST-BENEFIT ANALYSIS Lecture Eight
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ECONOMIC OPPORTUNITY COST OF LABOR
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• The Economic Opportunity Cost of Labor (EOCL) is
  the value to the economy of activities given up
  by workers including non-market costs (benefits)
  associated with the change in employment.
• Labor is not a homogeneous input.
• An externality (LEi) is created by any project,
  if the EOCLi differs from the wage rate (Wpi)
  paid by the project. Externality for a specific
  type of labor (i) can be expressed as
• LEi Wpi - EOCLi

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Estimates of the EOCL in Limpopo Province (South
Africa) (Rands per month)
Project Location Level of Skill Acquired Sources of Workers Project Wagea Prevailing Market Wagea EOCL Ratio of EOCL to Project Wage
Urban Urban Rural Rural Urban Urban Outside of Polokwane Urban Unskilledb Unskilledc Unskilledd Unskillede Skilledf Skilledg Skilledh Skilledi Local Local Local Local Elsewhere Elsewhere Urban Foreign 651 1,490 468 1,490 15,020 16,729 18,438 36,667 651 651 468 468 15,020 15,020 18,438 36,667 651 897 468 668 14,652 14,652 16,860 26,592 1.00 0.60 1.00 0.45 0.98 0.88 0.91 0.73
Note a. Project wage or prevailing market wage
refers to the gross wage including tax, social
security payments, and fringe benefits. b.
Unskilled worker employed in informal urban
labour market. c. Unskilled worker employed in
unionized urban labour market. d. Unskilled
worker employed in informal rural labour
market. e. Unskilled worker employed in unionized
rural labour market. f. Senior Site Engineer
technician employed in urban area. g. Senior Site
Engineer technician employed in urban area,
earning higher than market wage. h. Senior Site
Engineer technician employed in rural area,
earning market wage for region. i. Engineer with
skills that had to be sourced from abroad.
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• Estimation of the Economic
• Opportunity Cost of Labor
• Two approaches for the estimation of the EOCL
• value of marginal product of labor forgone
• ii) supply price of labor

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• Value of Marginal Product of
• Labor Forgone Approach
• Using this approach, the EOCL is determined by
• - starting with the gross-of-tax alternative
  wage (Wa) earned in previous employment by the
  labor hired for the project (marginal product
  forgone) and
• - and then adjusting for differences in other
  costs benefits.

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• Supply Price of Labor Approach
• Supply price is defined as the minimum
  gross-of-tax wage rate the project needs to pay
  to attract the necessary labor.
• Supply price accounts for a worker's preferences
  for location, working conditions, etc.
• Using the supply price approach, the EOCL is
  determined by
• starting with the market wage (the supply price)
  required to attract sufficient workers to the
  project and
• then adjusting for distortions such as taxes and
  subsidies.

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Example Comparing the Value of Marginal Product
Forgone and Supply Price Methods

• Unskilled farm workers move from (c) where they
  were cutting sugar cane to a more pleasant place
  (o) harvesting oranges.
• No distortions in the labor market
• Other factors influencing the relocation
• Difference in cost of living (C)
• Preference (S) of the workers for a more
  pleasant region.
•  
• Wo 15.00 per day Wc 20.00 per day
• Co 3.00 per day Cc 6.00 per day
• So 2.00 per day (value of the preference
  for the warmer region)

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• Example (contd)
• Marginal Product Approach
• EOCL prior wage - change in cost of living
• - worker preferences
• Wc - (Cc - Co) So
• 20 - (6 - 3) - 2
• 15.00 per day
• Supply Price Approach
• Supply price in (o) accounts for the cost of
  living difference (Cc - Co) and worker's
  preference for the better climate (So).
• EOCL Wo
• 15.00 per day

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• Structure of Analysis
• Labor prices can vary greatly
• Determinants in the cost of labor to the project
  
• Type of Labor (skilled vs. unskilled)
• Regional Variations and Domestic Migration
• International Migration
• Type of Labor Market (Protected vs.
  Unprotected)
• Type of Job (Permanent vs. Temporary)

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The Economic Opportunity Cost of Unskilled
Rural Labor

• EOCL of unskilled rural labor is not zero.
• The prevailing daily or weekly wage rate, W, (the
  supply price of unskilled labor) is a reflection
  of the marginal productivity of this type of
  activity.
• W is an effective measure of the value of forgone
  marginal product for unskilled labor.

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Supply Price Approach Calculations

• Determine the minimum gross-of-tax wage (market
  supply price) needed to attract sufficient
  unskilled labor to the positions available on the
  project.
• Identify the distortions in the labor market such
  as personal income taxes or unemployment
  insurance benefits.
• The EOCL can be determined by adjusting the
  market wage to compensate for the distortions
  caused by those factors.

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• The Economic Opportunity Cost of Unskilled Labor
  
• Example 1 Rural Labor Case without Seasonal
  Variation in Demand
• Assume
• no distortions in the unskilled labor market,
• no taxes paid by the employer (demand side),
• no income taxes paid by the worker (supply side),
  
• no fluctuations in wages or labor demand over
  time.
• The supply price of labor (WS) is equal to the
  prevailing market wage (W).
• EOCL W Supply Price of Unskilled Labor
• Note The EOCL is estimated using the market
  supply price (WS) not the project wage (Wp).

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• Due to seasonal fluctuations in the wage rate,
  the EOCL at any point in time is equal to the
  market wage rate (Wt) at that point in time.
• The total EOCL used by a project over a year is
  the sum of the product of the quantity of labor
  hired in each season (Qt) times the corresponding
  market wage rate (supply price, Wt) for the
  period
• where n is the total number of periods and
  t is the period of time.

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• Note
• The project wage (Wp) paid does not play a role
  in the estimation of the EOCL.
• Basis of estimation of the EOCL is the supply
  price of labor as reflected in the market wage
  (W).
• The difference between the financial cost paid by
  the project (Wp) and the EOCL is the value of the
  labor externality.

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Example Sugar Production Projects hires
Unskilled Labor in a Rural Area

• A labor-intensive sugar project
• Project requires unskilled workers on a temporary
  basis.
• Project pays a wage of 180 per month (Wp).
• Project working conditions are identical to those
  prevailing in the labor market.

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• Table shows the project's monthly labor
  requirement, the monthly market wage rates (W)
  that labor would be willing to work for on this
  project and the EOCL for each period.

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• The EOCL is calculated as follows
• Labor externality Financial Cost EOCL
• 18090
  12,690
• 3,510
• Labor externality is a net gain to labor.

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• The Economic Opportunity Cost of
• Skilled Labor
•  
• Skilled labor is not a homogeneous factor.
• Conversion factor for one type of occupation may
  not necessarily be the same for other
  occupations.
• Often labor must be induced with higher wages and
  improved benefits to migrate to other areas.
• Increase or decrease in the supply price of labor
  as it moves from one location to another will
  depend upon the magnitude of the consumer surplus
  lost or gained.

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• Situation 1 Labor Market without Distortions or
  Regional Migration
• Assume
• No distortions in the labor market
• No migration
• Project working conditions are identical to those
  prevailing in the labor market.
• The economic opportunity cost of labor is equal
  to the local market wage (W) which in this case
  is the supply price (Ws) 
• EOCL W Ws

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• Situation 2 Workers Migrate to Project from
• Distorted Regional Labor
  Markets
• Assume
• A proportion of the projects labor (Hd) is
  induced to migrate from alternative labor markets
  where they were employed.
• Project pays a wage equal or higher than the
  gross-of-tax supply price (Wgs) to attract the
  necessary workers.
• EOCL the supply price to the project, (Wgs)
• - taxes paid by project workers,
  (WgsT)
• taxes lost from the workers
  previous
• employment, (HdWaT).

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(No Transcript)
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1. Workers migrate from other regions to the
   project. Supply curve in the sending region (SS)
   shifts leftward to (SS).
2. At original wage (Wa), migration to the project
   will cause a decrease in the available supply
   from Q0 to Q1.
3. Wage increases to Wa to bring about an
   equilibrium. Higher wage in the sending regions
   causes employers to reduce the quantity they
   demand.
4. Higher wage also induces some skilled workers to
   enter the formal labor force, thereby increasing
   the quantity of skilled labor supplied from Q1 to
   Q2.
5. Net effect a proportion of the labor (Hs)
   ultimately comes from the newly induced supply
   and a proportion (Hd) comes from the reduced
   demand for workers elsewhere.
6. Reduction in the quantity of labor demanded
   results in a loss of taxes (ABCE).

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• When calculating the EOCL, only the tax
  distortion resulting from the reduced demand (Hd)
  need be accounted for, because we assumed that
  the increased supply (Hs) of labor is coming from
  non-market activities where there are no taxes or
  other distortions.
• Thus, the EOCL for the project in such cases is
  the gross-of-tax supply price (Wgs) of workers
  induced to move to the area minus the difference
  between the income taxes the workers would pay on
  this gross-of-tax supply price of labor (WgsT),
  which are gained by the government, and the
  income taxes previously paid by the workers in
  their alternative employment (HdWaT), which are
  lost by the government.

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• The EOCL hired by the project in the area is
• EOCL Wgs - (Wgs T HdWa T)
• where
• - Hd is the proportion of the project's demand
  for labor obtained from taxed employment
  activities in the alternative labor market,
• - Wa is the gross-of-tax wage of labor from
  alternative sources,
• - Wgs is the gross-of-tax supply price of labor,
• - T is the income tax rate levied on workers in
  all regions,
• - Hs (1 - Hd) includes both the supply of
  labor coming to the region from untaxed market
  and non-market activities, as well as increases
  in the labor force participation and the number
  of hours worked.

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• Labor Externality
• Labor externality can be expressed as
• LEi Wp - Wgs (WgsT - HdWaT)
• Wp (1 - T) - Wgs(1 - T) WpT HdWaT
• We can determine how these labor externalities
  are distributed between the workers and the
  government
• Labor benefits Wp(1 - T) - Wgs(1 - T)
• Government benefits WpT - HdWaT
• Thus, of the total of externalities created by
  the employment of workers by a project, labor
  will gain an additional income earnings while the
  government will capture additional taxes.
• The distributional analysis provides a means of
  evaluating the financial gains and losses
  affecting groups in the economy other than the
  owners of the project.

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Example Skilled Labor Hired for a Project

• In addition to the unskilled workers hired for
  the sugar project, the government requires each
  year 1,000 person-months of labor with skilled
  occupations.
• The project will have to attract skilled labor
  from the urban areas.
• These workers earn a monthly gross-of-tax salary
  (Wa) of 900 in the urban area, they will not
  work for less than 1,200 gross-of-tax for the
  project (Wgs). These wage rates reflect the
  gross-of-tax supply prices of the workers in the
  two markets, respectively.
• There is a policy of encouraging more workers in
  these occupations to migrate to the rural areas,
  so the project is required to pay a salary (Wp)
  of 1,500 per month for such labor, or 300 more
  than the market supply price.
• All skilled workers pay 20 of their wages in
  income taxes.

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• Example Skilled Labor (contd)
• The EOCL for this project is calculated
• EOCL Wgs - (WgsT - HdWaT)
• 1,200 (1,200 0.20) - (0.90 900
  0.20)
• 1,122/month
•  
• The labor externality can be expressed as The
  difference between the EOCL of these skilled
  workers and the value of the project's wage
• LEi Wp - EOCL
• 1,500 1,122
• 378/month

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• Example Skilled Labor (contd)
• These labor externalities can be distributed
  between the workers and the government
• Labor benefits Wp(1 - T) - Wgs(1 - T)
• 1,500(1 - 0.20) - 1,200(1 - 0.20)
• 1,200 - 960 240/month
• Government benefits WpT - Hd WaT
• 1,500(0.20) - (0.90 900 0.20)
• 300 - 162 138/month
•  
• Of the total of externalities created per month
  by the employment of workers by a project, labor
  will gain an additional 240 per month while the
  government will capture 138 per month in
  additional taxes.

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• EOCL if International Migration Flows
• -- Case 1 Retained or Returned Migrants --
• Project is created inside the country and
  additional labor is hired, a part of this labor
  is sourced from a reduction in the outflow of
  international migration.
• The availability of additional jobs in the
  country may induce some workers to return from
  abroad to seek local employment.
• The EOCL must take into consideration not only
  the adjustment of the demand and supply of labor
  in the local markets, but also any distortions
  associated with the retention or return of
  domestic workers who would have been employed
  abroad.
• Some citizens work abroad and send back a stream
  of payments in the form of personal savings or
  remittances to relatives. The reduction in
  remittances themselves is not an economic cost,
  because they are factored into the workers
  supply price to the project.

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• An adjustment needs to be made to the supply
  price of labor, since the foreign remittances are
  made in foreign exchange and a foreign exchange
  premium exists in most countries.
• The expression for the EOCL becomes 
• where
• Hd proportion of the projects demand for a
  given type of labor obtained from taxed
  employment activities in the domestic market.
• Hf proportion of the projects demand for a
  given type of labor obtained from reduced
  international out-migration.
• R the average amount of remittances
  (measured in local currency) that could have been
  made per period if this type of worker had been
  employed abroad.
• (Ee/Em 1) rate of the foreign exchange
  premium.

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• EOCL if International Migration Flows
• -- Case 2 Economic Opportunity Cost of Foreign
  Labor --
• There is an economic opportunity cost associated
  with hiring foreign labor (EOCLF) which should be
  included in the project assessment.
• The EOCLF is the net-of-tax wage paid to the
  foreign worker plus adjustments to the amount of
  foreign exchange associated with the repatriated
  portion, and adjustments to the amount of VAT
  associated with consumption by the foreign
  workers using the non-repatriated portion of that
  wage, plus any subsidies the foreign workers may
  benefit from while in the country.
• Foreign workers consumption in the country
  should be accounted for as an economic benefit to
  the country while the host-government subsidies
  to foreign workers on a variety of items such as
  food, fuel, housing and health care are an
  economic cost.

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• Case 2 (contd)
• The economic opportunity cost of foreign labor
  can be expressed as
• where
• WF gross-of-tax wage of foreign labor
• Th personal income tax levied by the host
  country on foreign labor
• tVAT VAT rate levied on consumption
• fr proportion of the net-of-tax income
  repatriated by foreign labor
• Ee economic exchange rate
• Em market exchange rate
• N value of benefits gained by foreign workers
  from subsidies
• If EOCLF is lower than the market wage, this
  means that the country is benefiting economically
  from the presence of foreign labor.

EOCLF WF(1-Th) - WF(1-Th)(1-fr)tVAT
WF(1-Th)fr(Ee/Em-1) N
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Example A Multinational Corporation Employing
Foreign Labor

• A multinational corporation considering an
  electronic assembly project in an urban area
  discovered that there was insufficient local
  labor.
• Import skilled workers from a nearby country
• 50 workers who will be paid 200 per month
• 25 personal income tax.
• Each worker is expected to repatriate 30 of her
  net-of-tax income to support family members at
  home.
• The VAT rate is 15.
• The economic value of foreign exchange is
  estimated to be 6 higher than the market value
  of exchange rate.
• Assume that there are no subsidies paid by the
  government with respect to these workers, i.e. N
  0.

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• Example (contd)
• Estimation of the EOCL
• 200(1 - 0.25) - 200(1 - 0.25)(1 -
  0.30)0.15
• 200(1 - 0.25)0.30(44.85/39) 1
• 150 - 15.75 6.75
• 141
• The economic opportunity cost of each worker will
  be 59 less than the gross-of-tax wage of 200.
• Hence, there is a beneficial externality created
  if the project uses foreign labor.

EOCLF WF(1-Th) - WF(1-Th)(1-fr)tVAT
WF(1-Th)fr(Ee/Em-1) N
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• Effects of a Protected Sector on the EOCL
• There is a segmentation of the urban labor market
  between a protected sector and an unprotected or
  open sector.
• The protected sector is usually made up of the
  government agencies, foreign companies, and large
  local firms which provide wages (Wp) above the
  market clearing wage.
• Employment in the protected urban labor force is
  highly desired, with a variety of rationing
  methods used to select the people to fill the
  limited number of positions.
• The open labor market is affected by fewer
  distortions to the supply price of labor (Wo).
  Wages are determined competitively in the
  marketplace where there are fewer barriers to
  entry, lower wages and less security of
  employment.
• While workers may be initially attracted to this
  labor market by the hope of finding a job in the
  protected sector, they often end up working in
  the open labor market.

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• EOCL in the Protected Sector (contd)

• Overall supply of labor is given by (SST)
• Total number of workers available for work at the
  protected sector wage of W is point C.
• The number of protected sector jobs available is
  much more limited at QPr.
• There is an excess supply of labor available at
  the protected sector wage, as shown by the
  quantity B .
• If the selection of workers for employment in the
  protected sector is done in a random fashion from
  the available workers, the supply of labor
  available to the open market will be a fraction
  (B/C) of the total labor supply SST at each wage
  rate. This labor supply is shown as the curve
  SSO.

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• EOCL in the Protected Sector (contd)
• Demand for labor in the open sector is perfectly
  elastic at a wage rate of WO, intersection of the
  demand for labor in the open sector (WODO) with
  the supply (SSO) determines the quantity employed
  in the open market. This quantity is indicated
  by point A1.
• The quantity of labor classified as unemployed
  (QQV) is determined from the difference between
  points A1 and B. These quasi-voluntary
  unemployed are those workers that will not choose
  to take jobs in the open market sector because
  their basic supply price of labor is above the
  open market wage (WO).
• Workers who actively seek jobs in the protected
  sector will consider themselves involuntarily
  unemployed. They are seeking work which will pay
  the protected sector wage (W), but are unable to
  find it.

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• Project in Protected Sector (contd)
• Adding a project to the protected sector
  increases the size of the protected sector from
  (C-B) to (C-B1). If additional workers (B-B1) are
  selected randomly from those remaining who want
  to work in the protected sector, the supply of
  labor to the open market will now shift to the
  left from SSO to SS1.

• The number of workers willing to take jobs in the
  open sector will fall from A1 to E.
• When workers are attracted from the unemployed
  and open sectors in proportion to their numbers
  in the labor pool, in the absence of any
  distortions, the economic opportunity cost of
  labor to this project is a weighted average of
  the open sector wage (WO), and the average supply
  price of the quasi-voluntary unemployed (WO
  WP)/2.
• The relevant weights are the proportions that
  people in each of those categories will be chosen
  for the protected sector jobs.

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• Project in Protected Sector (contd)
• The expression for the economic opportunity cost
  of protected sector jobs as
• EOCLP WO ? QO/(QOQQV)
• (WOW1P)/2 ? QQV/(QOQQV)
• When income taxes are levied on wages in the open
  sector, there is an additional economic cost to
  hiring workers from this open sector inclusive of
  income taxes.
• For the quasi-voluntary unemployed hired by the
  protected sector, their economic opportunity cost
  is the average of the net-of-tax open and
  protected sector wages in which the latter pay no
  taxes when unemployed.

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• EOCL with Two Protected Sectors
• The protected sector can contain a series of
  segmented markets, with different protected
  sector wages, Wp1, Wp2, ...Wpn.

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• EOCL with Any Protected Sector
• Under these conditions of a linear supply curve
  and a perfectly elastic demand for labor at the
  open wage of WO, the EOCL for any protected
  sector paying a wage, Wi, can be expressed as
• The EOCL for any protected sector is simply a
  weighted average of
• - the open sector wage, WO, and
• - the average of the specific protected sector
  wage and the open sector wage.
• The weights can all be expressed as functions of
  the original total market supply of labor STWi.

STWO
(STWiP-
EOCLiP WO (
)
STWiP
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• EOCL When Labor Not Employed Full Time
• -- Labor Employed Less than Full Year in Market
  Activities --
• Assume
• Each worker can spend part of each year working
  and part in non-market activities or
  unemployment.
• Workers are employed in market activities for a
  proportion (Pp) of the year if they work for the
  project.
• If not associated with the project, workers are
  employed a different proportion (Pa) of the
  year. No taxes on non-market activities.
• Wgs is the gross-of-tax supply price of skilled
  labor in the area of the project and Wa is the
  alternative wage which reflects this labor's
  other opportunities.

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• EOCL When Labor Not Employed Full Time (contd)
• The EOCL is equal to the gross-of-tax expected
  supply price for labor (Wgs), but only working a
  portion of the year on the project (Pp), minus
  the additional tax payments that the worker would
  incur if earning her supply price wage Wgs on
  this project.
• EOCL PpWgs - (PpWgs T - HdPaWaT)
• This additional tax is the difference between the
  tax paid on the project (PpWgsT) and the tax
  previously paid in the alternative mix of market
  activities (HdPaWaT).

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• EOCL When Labor Not Employed Full Time
• -- Permanent and Temporary Jobs with an
• Unemployment Insurance System and Labor Migration
  --
• We differentiate between those engaged in
  full-time and part-time employment.
• People in the permanent (or full-time) employment
  sector are almost never unemployed. Workers
  employed by temporary sectors such as tourism or
  construction are in jobs that are expected to be
  associated with repeated spells of employment.
• The type of employment created by a project is
  important.
• - Temporary jobs can have a higher economic cost
  than permanent job when UI payments are paid to
  these workers when they are unemployed but
  engaged in non-market activities.
• - These support payments affect the EOCL
  associated with a job.

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EOCL of Permanent Jobs

• When project creates new permanent jobs they will
  generally be filled by individuals already
  working in alternative permanent sector job, Hdp,
  other temporary sector jobs, Hdt, and some hired
  from those who are currently out of labor force,
  Hs. Thus, Hdp Hdt Hs 1.
• For those sourced from permanent sector
  externality of taxes lost of HdpWpT.
• For those sourced from the temporary sector there
  is loss in taxes, HdtPtWtT, and a gain in reduced
  UI payments, Hdt(1-Pt)fU(1-T), where f denotes
  the proportion of time an unemployed worker
  expects to collect UI benefits and U denotes the
  amount of UI benefits.
• No externalities for share Hs are sourced from
  outside labor force. Thus,
• EOCLP Wgs(1 T) HdpWpT HdtPtWtT (1
  Pt)fU(1 T)

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EOCL of Permanent Jobs (contd)

• If unemployment insurance
• EOCLP Wgs(1 T) HdpWpT HdtPtWtT (1
  Pt)fU(1 T)
• If no unemployment insurance
• EOCLP Wgs(1 T) HdpWpT HdtPtWtTt

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EOCL for Temporary Sector Jobs

• Creation of 12 months of temporary sector
  employment is equal to a person year job.
• Workers sourced in proportions, Hdp, Hdt, Hs
  permanent, temporary employment and supply of
  labor who were previously out of the labor
  market.
• Pt is the proportion of time a person actually
  works per year in a temporary sector job per
  year.
• For each period of labor services sourced from
  the permanent sector there will be 1/Pt
  individuals, (1Pt)/Pt period of unemployment,
  and f(1Pt)/Pt periods of paid UI compensation.

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EOCL for Temporary Sector Jobs (contd)

• EOCL of 12 months of temporary sector job is
• EOCLT Wgs(1 T) (Hdp/Pt) WpT (1
  Pt)fU(1T) HdtWt(Tt) (Hs/Pt )(1-Pt)fU(1
  Tt)
• In the case where the supply price Wgs is the
  same for both permanent and temporary job then
  EOCLT gt EOCLP for a 12-month job.
• A greater amount of taxes will be lost if
  temporary jobs and UI increased.