Key Points for Class Topic & Chapter 1:
Economic Models, Why Firms Hire Permanent Employees, Principal-Agent Issues, and
Heterogeneous vs. Homogeneous Workers and Firms
In labor markets (and markets for other factors of production), firms are on the
buying/demand side of the market, while individuals/households are on the seller/supply
If two or more people in a household make joint decisions about labor supply vs.
leisure and non-marketed household production activities (such as cooking, cleaning, child
care, etc.) then some of the labor supply decisions are joint/household decisions.
The demand for labor (and other factors of production) is a derived demand – which
means it depends on the demand for the product labor is used to produce.
For example, if
the demand for automobiles decreases, then the demand for workers in the automobile
industry will decrease, other things being equal.
In the simplest model of a labor market, firms are typically shown hiring more workers, or
more hours of work, as the price of labor decreases.
The price of labor is often shown as
the wage rate.
That is a simplification/generalization, because some workers are paid
salaries rather than wages, and others are paid piece rate or commissions and bonuses
related to different measures of the worker’s output rather than hours of input.
workers receive fringe benefits as substantial parts of their total compensation, not just
A key point to recognize about all economic models is that they are simplifications of
That is done intentionally so that the conclusions of the models will be more
general, applying to a wide range of workers, firms, and labor markets.
That is the
difference between an analytical model and a descriptive model that tries to be very
detailed and realistic in appearance (for example, think of the model kits for airplanes,
The purpose of analytical models is to explain and predict outcomes, and
models are judged by how well they predict, not by the level of detail and description built
into the assumptions used to build the model.
The more detailed and specific a model
becomes, the less general it will be.
How detailed to make the model therefore depends on
how general or specific the questions are that you want the model to answer, or at least
Normative questions often influence the questions that are addressed by positive economic
models, and policy recommendations that are at least partly based on the cause and effect
or if/then predictions of the positive models.
The predictions from a positive model are
typically amoral, not based on questions of right or wrong, or what people believe should
happen to make the word better and more fair/equitable.
So normative issues often depend
on comparisons of how much some people or groups are helped or hurt by a policy, not just
the total estimates of costs and benefits.
However, the compensation principle suggests that
Key Points for ECON 385, Spring 2011, M. Watts, Page