Chapter 6

Wage Determination and the

Allocation of Labor

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

1. Theory of a Perfectly
Competitive Labor
Market

6-2

Perfectly Competitive Labor

Market
o Perfectly competitive labor markets have
the following characteristics:
Large number of firms trying to hire an
identical type of labor
Numerous qualified people independently
offering their services
Neither firms nor workers have control over
the market wage
Perfect, costless information and labor
mobility
6-3

 Though individuals have

backward-bending labor supply
curves, market supply curves
are usually positively sloped
over normal wage ranges.

Wage rate

Market Labor Supply

S

High relative wages attract

workers away from household
production, leisure, or their
previous jobs.
The height of the market
supply curve measures the
opportunity cost of using the
marginal labor hour in this
employment.
The shorter the time period,
the less elastic is the labor
supply curve.

Quantity of
Labor Hours
6-4

Wage and Employment

Determination
Wage rate

The equilibrium wage rate W0

and level of employment Q0
Wes
occur at the intersection of labor
supply and demand.
W0
An excess demand of Q2- Q1
Wed
would occur at a wage rate of
Wed.

An excess supply of Q2- Q1

would occur at a wage rate of
Wes.
Q1

Q0

Q2

Quantity of
Labor
Hours
6-5

Labor Supply Determinants

Labor Supply will change if there are
changes in the following factors:
o Other wage rates
o Nonwage income
o Preferences for work versus leisure
o Nonwage aspects of job
o Number of qualified suppliers
6-6

Labor Supply Determinants

o Other wage rates
If wages in other occupations rise (fall), then
labor supply will fall (rise).

o Nonwage income
If nonwage income rises (falls), then labor
supply will fall (rise).

o Preferences for work versus leisure

If preferences for work increase (decrease),
then labor supply will increase (decrease).
6-7

Labor Supply Determinants

o Nonwage aspects of job
If the nonwage aspects of a job improve
(worsen), then labor supply will increase
(decrease).

o Number of qualified suppliers

An increase (decrease) in the number of
qualified workers will increase (decrease)
labor supply.

6-8

Labor Demand Determinants

Labor Demand will change if there are
changes in:
o Product demand
o Productivity
o Prices of other resources
Gross substitutes
Gross complements

o Number of employers
6-9

Labor Demand Determinants

o Product demand
Changes in product demand that
increase (decrease) the product price, will
increase (decrease) labor demand.

o Productivity
An increase (decrease) in productivity will
increase (decrease) labor demand,
assuming that it does not cause an offset
in the product price.

6-10

Labor Demand Determinants

o Prices of other resources
For gross substitutes, an increase
(decrease) in the price of a substitute
input will increase (decrease) labor
demand.
For gross complements, an increase
(decrease) in the price of a complement
input will decrease (increase) labor
demand.

6-11

Labor Demand Determinants

o Prices of other resources
For pure complements, an increase
(decrease) in the price of a complement
input will decrease (increase) labor
demand.

o Number of employers
An increase (decrease) in the number of
employers will increase (decrease) labor
demand.
6-12

Changes in Labor Demand

Assume that the productivity
of workers rises due to
computer innovations.

Wage rate

W1
This will raise the marginal
product and thus shift the
labor demand curve to the
right (D0 to D1).

W0
D1
D0

The equilibrium wage rate

will rise to W1 and equilibrium
quantity will rise to Q1.
Q0 Q1

Quantity of
Labor Hours
6-13

Changes in Labor Supply

Wage rate

S0

Assume that the number of

working-age immigrants
increases substantially.
This will shift the labor
supply curve to the right (S0 to
S1).

S1
W0
W1
D0

The equilibrium wage rate

will fall to W1 and equilibrium
quantity will rise to Q1.
Q0 Q1

Quantity of
Labor Hours
6-14

Labor Market Demand & Supply

Elasticities
o Wage Elasticity of Labor Demand
Inelastic: very little change in the number of jobs if
wages change
Elastic: a large change in the number of jobs if
wages change

o Wage Elasticity of Labor Supply

Inelastic: very little change in the number of job
seekers if wages change
Elastic: a large change in the number of job
seekers if wages change
6-15

Digression: Labor Supply

Elasticity Determinants
Key:
Are individuals willing & able to enter and exit
an occupation if wages either increase or
decrease?
Elastic Supply: workers are willing & able to
enter if wages increase and leave if wages
decrease
Inelastic Supply: workers are unwilling & unable
to enter if wages increase and leave if wages
decrease
6-16

Digression: Labor Supply

Elasticity Determinants
o Labor Supply will be more/less elastic if:
Relative wages are low/high
Relative training/skills are low/high
Training/skills can/cant be transferred from
other occupations
Nonwage benefits of the job arent/are
important
Typical jobs require relatively few/many hours
per week (Income vs. Substitution Effect)
6-17

Digression: Labor Demand Elasticity

Determinants
Key:
Are employers willing & able to increase or
decrease the number of persons hired in an
occupation if wages either decrease or increase?
Elastic Demand: firms are willing & able to
decrease employment if wages increase and
increase employment if wages decrease
Inelastic Demand: firms are willing & able to
decrease employment if wages increase and
increase employment if wages decrease
6-18

Digression: Labor Demand

Elasticity Determinants
o Labor demand will be more/less elastic if
Customers do/dont care about product price
Labor costs are a large/small part of total
costs
Substitutes for labor do/dont exist
Supplies of labor substitutes are ample/scarce

6-19

Equilibrium Changes and the Labor

Demand Elasticity
o If labor supply increases and labor
demand is inelastic
Wages will decrease a lot
Employment will increase a little
Total wages to workers will decrease

o If labor supply increases and labor

demand is elastic
Wages will decrease a little
Employment will increase a lot
Total wages to workers will increase
6-20

Equilibrium Changes and the Labor

Demand Elasticity

6-21

Equilibrium Changes and the Labor

Demand Elasticity
o If labor demand increases and labor
supply is inelastic
Wages will increase a lot
Employment will increase a little

o If labor demand increases and labor

supply is elastic
Wages will increase a little
Employment will increase a lot

o Rising labor demand increases total wages and

falling labor demand decreases total wages
6-22

Equilibrium Changes and the Labor

Supply Elasticity

6-23

Wage and Employment for Firms with

Competitive Product & Labor Markets
Assume wages are the only
cost
a firm hiring in a perfectly
competitive labor market is a
wage taker. Its labor supply
curve, SL=MLC=PL, is perfectly
elastic at W0.
A firm will hire another
worker if the additional
revenue the worker generates,
marginal revenue product
(MRP), is greater than the cost
of hiring an additional worker,
marginal labor cost (MLC).
The firm maximizes its profits
by hiring Q0 units of labor
(MRP=MLC).

Wage rate

SL=MLC=PL

W0

DL=MRP=VMP

Q0

Quantity of
Labor Hours
6-24

Allocative Efficiency
o An efficient allocation of labor is
obtained when society gets the largest
possible amount of output from a given
amount of labor.
o Efficient allocation requires the VMP of
labor for each product be equal to the
price of labor.
o Perfect competition in the product and
labor markets creates allocative
efficiency.
6-25

Questions for Thought

1. What effect will each of the following have on
the market demand for a specific type of labor:
(a) An increase in product demand that increases the
product price.
(b) A decline in the productivity of this type of labor.
(c) An increase in the price of a gross substitute of labor.
(d) An increase in the price of a gross complement of
labor.
(e) The demise of several firms that hire this type of
labor.
(f) A decline in the market wage for this type of labor.

6-26

2. Wage and
Employment
Determination: Market
Power in the Product
Market
6-27

Wage and Employment for Firms with NonCompetitive Product Markets

Assume wages are the only
cost
Because a monopolist faces a
downward sloping demand
curve, increased hiring of labor
and the resulting larger output
force the firm to lower its price.
Because it must lower its
price on all units, its marginal
revenue (MR) is less than the
price.
The firms MRP curve (MP *
MR) lies below the VMP curve
(MP * P), and thus firm hires QM
rather than QC.
An efficiency loss of abc
results.

Wage rate
b
W0

SL=MLC=PL

DC=VMP (MP*P)
DM=MRP (MP*MR)
QM

QC

Quantity of
Labor Hours
6-28

Questions for Thought

1. Complete the following table for a firm operating
in labor market A and product market AA.
Labor

Wage

TLC

MLC

MRP

VMP

$10

$16

$16

$10

$14

$15

$10

$12

$14

$10

$10

$12

$10

$8

$10

$10

$6

$8

(a) What can we conclude about the degree of

competition in the labor market and product market?
(b) What is the profit maximizing level of employment?
6-29

3. Market Power in the

Labor Market: the Case
of Monopsony

6-30

Monopsony
o A monopsony is a labor
market where a single firm is
the sole hirer of a particular
type of labor.
A monopsonist has control over
the wage rate workers are paid
by hiring more or less labor.

6-31

Monopsony
A monopsonist faces an upward sloping labor curve. It has to pay a
higher wage to get more workers.
The total labor cost (TLC) to the firm is calculated as the number of units
of labor times the wage rate (assuming no other costs when hiring).
The firm maximizes profits by hiring MRP = MLC at 3 units.
The marginal labor cost (MLC) is the additional cost of hiring the last
worker.
Units of
Labor (L)

Wage

TLC

(2)

(3)

0
1
2
3
4
5
6
7

$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00

----$2
$6
$12
$20
$30
$42
$56

(1)

MLC
(4)

--$ 2
$ 4
$ 6
$ 8
$10
$12
$14

(VMP)
MRP
(5)

$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$4
$3
6-32

Wage and Employment

for a Monopsonist
The firms MLC lies above
the SL.
The monopsonist equates its
MRP with its MLC at point a
and hires QM units of labor.
To attract these workers, it
need only pay WM.
The firm thus pays a lower
wage (WM rather than WC) and
hires fewer units of labor (QM
instead of QC) than firms in a
competitive labor market.
An efficiency loss of abc
results.

MLC

Wage rate

SL=PL
a
WC
WM

c
b
DL=MRP=VMP
QM QC

Quantity of
Labor Hours
6-33

Baseball Free Agency

o Before 1976, baseball players were bound
to single teams = monopsony power. In
1976, players could become free agents
after 6 years
o Theory says that pre 1976 players should
have been paid far less than MRP
Studies confirm, with star pitchers only
receiving 21% of their MRPs, bad pitchers
receiving 54% and bad hitters receiving 37%.
6-34

 After free-agency, market competition reduced

monopsony power
Wages soared to more closely match MRP

6-35

4. Wage Determination:
Delayed Supply
Responses

6-36

Cobweb Model
The market for highly trained
professionals such as nurses
has delayed supply responses
to changes in demand and
wage rates.
Because the quantity of labor
supplied is temporarily fixed at
Q0, the wage rate rises to W1
when demand changes from D0
to D1.
At wage rate W1, Q1 nurses
are attracted to the profession.
With supply fixed at Q1, the
wage rate falls to W2.
With this wage rate, the
quantity of nurses falls over
time to Q2.
The cycle repeats until
equilibrium is achieved at the
intersection of S and D.

Wage rate
W1
W2
W0

D1
D0

Q0 Q 2

Q1 Quantity of
Labor Hours
6-37

Evidence
o Some evidence exists for cobweb
adjustments in markets such as
lawyers and engineers.
o Critics argue that:
Students make choices on the basis of the
lifetime earnings stream rather than
starting salaries.
Students make a forecast of the long-run
outcome of a change in demand or supply
and make the right choice.
6-38