Labor Market Equilibrium and Wage Determinants _ Boundless Economics.pdf

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Unformatted text preview: 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Boundless Economics Inputs to Production: Labor, Natural Resources, and Technology Labor Market Equilibrium and Wage Determinants … 1/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Conditions of Equilibrium Equilibrium in the labor market requires that the marginal revenue product of labor is equal to the wage rate, and that MPL/PL=MPK/PK. LEARNING OBJECTIVES Employ the marginal decision rule to determine the equilibrium cost of labor KEY TAKEAWAYS Key Points Firms will hire more labor when the marginal revenue product of labor is greater than the wage rate, and stop hiring as soon as the two values are equal. The point at which the MRPL equals the prevailing wage rate is the labor market equilibrium. The marginal decision rule says that a rm will shift … 2/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics The marginal decision rule says that a rm will shift spending among factors of production as long as the marginal bene t of such a shift exceeds the marginal cost. If the marginal bene t of additional labor, MPL/PL, exceeds the marginal cost, MPK/PK, then the rm will be better o by spending more on labor and less on capital. According to the marginal decision rule, equilibrium in the labor market must occur where MPL/PL=MPK/PK. Key Terms marginal product: The extra output that can be produced by using one more unit of the input. marginal revenue product: The change in total revenue earned by a rm that results from employing one more unit of labor. capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and o ce buildings (structures). The labor market di ers somewhat from the market for goods and services because labor demand is a derived demand; labor is not desired for its own sake but rather because it aids in producing output. Firms determine their demand for labor through a lens of pro t maximization, ultimately seeking to produce the optimum level of output and the lowest possible cost. Labor Market Equilibrium In order to nd the equilibrium quantity and price of labor, economists generally make several assumptions: The marginal product of labor (MPL) is decreasing; Firms are price takers in the goods market (cannot a ect the price … 3/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Firms are price-takers in the goods market (cannot a ect the price of output) as well as in the labor market (cannot a ect the wage rate); The supply of labor is elastic and increases with the wage rate (upward sloping supply); and Firms are pro t-maximizers. The marginal revenue product of labor (MRPL) is equal to the MPL multiplied by the price of output. The MRPL represents the additional revenue that a rm can expect to gain from employing one additional unit of labor – it is the marginal bene t to the rm from labor. Under the above assumptions, the MRPL is decreasing as the quantity of labor increases, and rms can increase pro t by hiring more labor if the MRPL is greater than the marginal cost of that additional unit of labor – the wage rate. Thus, rms will hire more labor when the MRPL is greater than the wage rate, and stop hiring as soon as the two values are equal. The point at which the MRPL equals the prevailing wage rate is the labor market equilibrium. Optimal Demand for Labor: The optimal demand for labor is located where the marginal product equals the real wage rate. The curved line represents the falling marginal product of labor, the y-axis is the marginal product/wage rate, and the x-axis is the quantity of labor. Optimizing Capital and Labor In the long run rms maximize pro t by choosing the optimal … 4/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics In the long run, rms maximize pro t by choosing the optimal combination of labor and capital to produce a given amount of output. It’s possible that an automobile company could manufacture 1,000 cars using only expensive, technologically advanced robots and machinery (capital) that do not require any human participation. It’s also possible that the company could produce the same number of vehicles using only employee work (labor), without any assistance from machines or technology. For most industries, however, relying solely on capital or solely on labor is more expensive than using some combination of the two. Factory Worker: Most rms need a combination of both labor and capital in order to produce their product. Firms use the marginal decision rule in order to decide what combination of labor, capital, and other factors of production to use in the creation of output. The marginal decision rule says that a rm will shift spending among factors of production as long as the marginal bene t of such a shift exceeds the marginal cost. Imagine that a rm must decide whether to spend an additional dollar on labor. To determine the marginal bene t of that dollar, we divide the marginal product of labor (MPL) by it’s price (the wage rate, PL): MPL/PL. If capital and labor are the only factors of production, then spending an additional $1 on labor while holding the total cost constant means taking $1 out of capital. The cost of that action will be the output lost from cutting back on capital which is the ratio of the marginal product of capital (MPK) to … 5/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics on capital, which is the ratio of the marginal product of capital (MPK) to the price of capital (the rental rate, PK). Thus, the cost of cutting back on capital is MPK/PK. If the marginal bene t of additional labor, MPL/PL, exceeds the marginal cost, MPK/PK, then the rm will be better o by spending more on labor and less on capital. On the other hand, if MPK/PK is greater than MPL/PL, the rm will be better o spending more on capital and less on labor. The equilibrium – the point at which the rm is producing the maximum amount of output at a given cost – occurs where MPL/PL=MPK/PK. The Wage Rate The wage rate is determined by the intersection of supply of and demand for labor. LEARNING OBJECTIVES Describe the factors that determine the wage rate KEY TAKEAWAYS Key Points An increase in demand or a reduction in supply will raise wages; an increase in supply or a reduction in demand will lower them. The demand curve depends on the marginal product of labor and the price of the good labor produces. If the demand curve shifts to the right, either because productivity or the price of output has increased, wages will be pushed up. In the long run the supply of labor is simply a function of … 6/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics In the long run the supply of labor is simply a function of the population size, but in the short run it depends on variables such as worker preferences, the skills and training a job requires, and wages available in alternative occupations. Key Terms marginal product: The extra output that can be produced by using one more unit of the input. Union: an organization of workers who have banded together to achieve common goals When labor is an input to production, rms hire workers. Firms are demand labor and workers provide it at a price called the wage rate. Colloquially, “wages” refer to just the dollar amount paid to a worker, but in economics, it refers to total compensation (i.e. it includes bene ts). The marginal bene t of hiring an additional unit of labor is called the marginal product of labor: it is the additional revenue generated from the last unit of labor. In theory, as with other inputs to production, rms will hire workers until the wage rate (marginal cost) equals the marginal revenue product of labor (marginal bene t). Changes in Supply and Demand In competitive markets, the demand curve for labor is the same as the marginal revenue curve. Thus, shifts in the demand for labor are a function of changes in the marginal product of labor. This can occur for a number of reasons. First of all, you can imagine that a new product or company is created that represents new demand for labor of a certain type. There are also three main factors that would shift the labor demand curve: . Technology which a ects the output of a unit of labor. . Changes in the price of the output which a ect the value of the unit of labor. Changes in the price of labor relative to other factors of … 7/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics . Changes in the price of labor relative to other factors of production. In the long run, the supply of labor is a function of the population. A decrease in the supply of labor will typically cause an increase in the wage rate. The fact that a reduction in supply tends to strengthen wages explains why unions and other professional associations have often sought to limit the number of workers in their particular industry. Physicians, for example, have a nancial incentive to enforce rigorous training, licensing, and certi cation requirements in order to limit the number of practitioners and keep the labor supply low. Wage Rate in the Long Run: In the long run the supply of labor is xed and demand is downward-sloping. The wage rate is determined by their intersection. Compensation Di erentials Some di erences in wage rates across places, occupations, and demographic groups can be explained by compensation di erentials. LEARNING OBJECTIVES Describe nonmonetary factors that a ect wage rates … 8/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Describe nonmonetary factors that a ect wage rates KEY TAKEAWAYS Key Points Although basic economic theory suggests that there ought to be one prevailing wage rate for all labor, this is not the case. Wage di erences are called compensation di erentials and can be explained by many factors, such as di erences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves. One common source of di erences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher. If a certain area is a desirable place to live, the supply of labor will be higher than in other areas and wages will be lower. This is a type of geographical di erential. Discrimination against gender or racial groups can cause compensation di erentials. A compensating di erential is the additional amount of income that a given worker must be o ered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. Key Terms di erential: a qualitative or quantitative di erence between similar or comparable things discrimination: Distinct treatment of an individual or group to their disadvantage; treatment or consideration based on class or category rather than individual merit; … 9/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics based on class or category rather than individual merit; partiality; prejudice; bigotry. According to the basic theory of the labor market, there ought to be one equilibrium wage rate that applies to all workers across industries and countries. Of course this is not the case; doctors typically make more per hour than retail clerks, and workers in the United States typically earn a higher wage than workers in India. These wage di erences are called compensation di erentials and can be explained by many factors, such as di erences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves. Education Di erentials One common source of di erences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher. Additionally, the di erential pay for more education tends to compensate workers for the time, e ort, and foregone wages from obtaining the necessary training. If all jobs paid the same rate, for example, fewer people would go through the expense and e ort of law school. The compensation di erential ensures that individuals are willing to invest in their own human capital. … 10/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Education Di erentials: Workers seek increased compensation by attaining higher levels of education Geographic Compensation Di erentials If a certain part of a country is a particularly attractive area to live in and if labor mobility is perfect, then more and more workers will move to that area, which in turn will increase the supply of labor and depress wages. If the attractiveness of that area compared to other areas does not change, the wage rate will be set at such a rate that workers will be indi erent between living in areas that are more attractive but with a lower wage and living in areas which are more attractive with a higher wage. In this way, a sustained equilibrium with di erent wage rates across di erent areas can occur. Discrimination and Compensation Di erentials In the United States, minorities and women make lower wages on average than Caucasian men. Some of this is due to historical trends a ecting these groups that result in less human capital or a concentration in certain lower-paying occupations. Another source of di ering wage rates, however, is discrimination. Several studies have shown that, in the United States, several minority groups (including black men and women, Hispanic men and women, and white women) su er from decreased wage earning for the same job with the same … 11/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics from decreased wage earning for the same job with the same performance levels and responsibilities as white males. Compensating Di erential Not to be confused with a compensation di erential, a compensating di erential is a term used in labor economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. It is de ned as the additional amount of income that a given worker must be o ered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. One can also speak of the compensating di erential for an especially desirable job, or one that provides special bene ts, but in this case the di erential would be negative: that is, a given worker would be willing to accept a lower wage for an especially desirable job, relative to other jobs.. … 12/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Hazard Di erential: Hazard pay is a type of compensating di erential. Occupations that are dangerous, such as police work, will typically have higher pay to compensate for the risk associated with that job. Performance and Pay Theoretically there is a direct connection between job performance and pay but in reality other factors often distort this relationship … 13/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics pay, but in reality other factors often distort this relationship. LEARNING OBJECTIVES Identify the relationship between performance and wages KEY TAKEAWAYS Key Points According to economic theory, workers’ wages are equal to the marginal revenue product of their labor. If one employee is very productive he or she will have a high marginal revenue product. In reality, wages are determined not only by one’s productivity, but also by seniority, networking, ambition, and luck. Some of the disconnect between performance and pay can be addressed with alternate pay schemes. Key Terms commission: A fee charged by an agent or broker for carrying out a transaction piece work: Work that a worker is paid for according to the number of units produced, rather than the number of hours worked. According to economic theory, workers’ wages are equal to the marginal revenue product of their labor. If one employee is very productive he or she will have a high marginal revenue product: one additional hour of their work will produce a signi cant increase in output. It follows that more productive employees should have higher wages than less … 14/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics more productive employees should have higher wages than less productive employees. Imagine if this were not true: a rm decides to pay a highly productive worker less than the marginal revenue product of his labor. Any other rm could make a pro t by o ering a higher salary to attract the productive employee to their company, and the worker’s wage would rise. Theoretically, therefore, there is a direct relationship between job performance and pay. We know that this is not always the case in reality. Wages are determined not only by one’s productivity, but also by seniority, networking, ambition, and luck. It is very rare for an entry-level worker to make the same wage as an experienced member of the same profession regardless of their relative levels of productivity because the older worker has had time to receive pay raises and promotions for which the younger employee is simply not eligible. Discrimination is sometimes responsible for members of minority racial or gender groups receiving wages that are less than wages for the majority group even when productivity levels are the same. Finally, outside forces, such as unions or government regulations, can distort pay rates. Wages and Productivity in the U.S.: On a macroeconomic level, this graph shows the disconnect, beginning around 1975, between the productivity of labor and the wage rate in the U.S. If the economic theory were correct in the real world, wages and productivity would increase together. Linking Performance and Pay … 15/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics Linking Performance and Pay Some of the disconnect between performance and pay can be addressed with alternate pay schemes. While a salary or hourly pay does not directly take into account the quality of work, performance-related pay compensates workers with higher levels of productivity directly. One example is commission-based pay. In this type of pay scheme, workers receive some percentage of the pro t that they generate for their company. This may be paid on top of a baseline salary or may be the only form of compensation. This type of system is very common among car salespeople and insurance brokers. Another alternative is piece-work, in which employees are paid a xed rate for every unit produced or action performed, regardless of the time it takes. This is common in settings where it is easy to measure the output of piece work, such as when a garment worker is paid per each piece of cloth sewn or a telemarketer is paid for every call placed. Marginal Revenue Productivity and Wages In a perfectly competitive market, the wage rate is equal to the marginal revenue product of labor. LEARNING OBJECTIVES Explain how wages are determines by marginal revenue productivity KEY TAKEAWAYS Key Points In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for … 16/25 11/10/2020 Labor Market Equilibrium and Wage Determinants | Boundless Economics changes in wage rates we focus on the demand for labor. The marginal product of labor (MPL) is the increase in output that a rm experiences from adding one additional unit of labor. The marginal bene t to the rm of hiring an additional unit of labor is called the marginal revenue product of labor (MRPL). It is calculated by multiplying MPL by the pric...
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