LABOUR ECONOMICS
by Jeremiah Allen
Associate Professor of Economics
University of Lethbridge
©2001
CHAPTER ONE
1-1 Introduction
Every day people go to work or school, or stay home and clean the house, wash the clothes and
care for children. The study of labour economics is the study of how these decisions are made: how
people decide what to do with their time, how firms decide how many people to employ, and how
these interact to determine the wages that are paid for various tasks. The study of labour economics
is also the study of the consequences of these decisions on society.
Labour is a special market. Ask a person “What are you”, and the odds are that that person will
reply with his or her job. Ask me, and I will usually say “I’m an economist”, or “I’m a university
professor”. I am also a father, husband, son and brother; I’m a man, a Canadian, my heritage is
American; I’m a keen hiker and skier. But if asked to define myself, I will usually reply with what I
do in the labour market. This is almost certainly true of most people.
The “labour market” is also special because it’s where we earn our “bread”. Most income
received in North America is income earned in the labour market. As described above, how a
person earns her/his income defines the person in interesting ways. But it is also true that how
much a person earns helps to define her/his life. The ability to have the better things of life, to
travel, to ski, to own a condo in Whistler, all, for most people, depend on the result of their
interaction with the labour market.
Because the labour market is a special market, it matters in ways that other markets don’t. If
the demand for, say cola, dropped by 20 percent over a few years, it would have an impact, but even
then that impact would most likely be noticed for its effect on the workers in the cola industry. But
when the labour market did that in the early 1930s, 20% of the nation’s workers lost their earnings,
and the consequences were a national disaster. The social consequences of decisions made in the
labour market have greater importance than the social consequences of decisions made in product
markets. Yet, curiously, formal economics gives far more attention to product markets. Courses in
microeconomic theory, from the introductory level to post-graduate, normally devote far more
attention to product markets than they do labour markets.
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The phrase, “The Labour Market” is a bit of shorthand which we now abandon. In a modern
industrial economy, such as the US’s and Canada’s, there is no longer any such thing as the labour
market. What characterizes these economies are a very large number of markets for a very large
number of different skills. Thus, in this book we develop a models of markets for different skills.
These skills are embodied in people, so it is appropriate to model these skill inputs as the
“labour” of the people with the relevant skills. It is also appropriate to treat the input as the time –
hours, days, years – spent “labouring” by the people with these skills. But it is inappropriate to
model a single “labour market” in which all the individuals, and all the firms, in the economy
participate. The demand for brain surgeons is obviously separate from the demand for major league
shortstops, and each of these is equally obviously separate from the demand for hamburger flippers
in fast food chains. They are essentially completely independent of one another. So we treat them
as separate.
Likewise, it is inappropriate to talk about “the” wage. There is a market for each skill, so each
skill has a unique wage. The wage of brain surgeons is obviously different from the wage of major
league shortstops, and each is equally obviously different from the wage of hamburger flippers in
fast food chains. So we treat the determination of the wages separately.
These two differences between what has become conventional will make little or no difference in
the first part of the book. In that part we look at the demand for skills, skills embodied in people
which emerge through the “labour” of those people. But in doesn’t really matter if we call the
horizontal axis there “labour” or “hours of skill provided”. Only one interesting point in the
analysis of demand arises from the treatment here: that there are a large number of markets for a
large number of relatively independent skills, each establishing a relatively independent wage for
that skill. That point is that monopsony, which is highly improbable if there is “a labour market”, is
quite plausible, and possibly the norm, in the many individual markets for different skills.
1-2 On Models and Markets
Economics is the study of the allocation of scarce resources to unlimited wants. It uses models
to analyze the way resources are allocated by markets. Economic models are simplified views of
economic reality. Economic reality, in Canada, is 35 million people, making thousands of decisions
every day. We cannot possibly observe full economic reality, it is far too complex. So we simplify.
We simplify in order to understand, and in order to be able to organize our observations of “the
economy”. For example, we read today in the newspaper that 18 million people are in the labour
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force, and that unemployment is about 6%, or roughly 1,100,000 people. We cannot observe the
nearly 17 million going to work, or the 1,100,000 searching for work. What we do is to have
models which tell us what unemployment is, and we summarize economic reality by saying
unemployment is 6% of the labour force.
The models used in this textbook are all based on a broad theory, known as neo-classical
economic theory. In neo-classical economics, private agents are classed into two broad categories:
Households and Business Firms. Households make two types of decisions: 1) They decide how to
spend their limited incomes buying various goods and services from Firms in Product Markets. 2)
They decide how much of their scarce resources, in particular how much of their labour, they will
rent to Firms in the Resource, or Factor Markets in order to earn income. Business Firms make
three types of decisions: 1) They decide how much of various scarce resources they will employ in
the Resource Markets. 2) They decide how to produce the various goods and services. 3) They
decide how much of these to produce and offer for sale in the Product Markets.
The decisions of Households determine the Demand functions in the individual Product
Markets, and decisions of Households determine the Supply functions in individual Resource
Markets. The decisions of Firms determine the Supply functions in Product Markets, and decisions
of Firms determine Demand functions in Resource Markets. Here, in Labour Economics, we are
particularly interested in the Supply of labour to, and the Demand for labour from, the many
individual skill markets.
In neo-classical economics, Households are characterized by their utility functions, and they
are motivated to maximize utility. A Household’s ability to maximize utility is constrained by two
types of factors: physical and social, or economic. The physical constraint is time. Everyone is
limited to 24 hours a day, or, if we recognize the constraints that require a human body to sleep and
eat, to roughly 14 hours a day. The economic constraints come from the markets. They are prices
in the Product Markets, and wages in the skill markets. This constrained maximization of utility
lies behind the decisions which determine Demand in the Product Markets and Supply in the
Resource Markets.
Business Firms are characterized by production functions, and they are motivated to maximize
profits. Business Firms are also constrained by two factors: physical and social/economic. The
physical constraints are represented by the production function. They are the physical nature of the
production process, which includes the state of technology, and time. The economic constraints
come from the markets. They are prices and wages if the markets are competitive, Demand if the
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Product Market is monopolistic, and Supply if the Resource Market is monopsonistic.
The
constrained maximization of profits underlies the decisions which determine Supply functions in the
Product Markets and Demand functions in the Resource Markets.
The agents, and the relation between the agents and the two types of markets, are shown in the
following simple diagram of an economy:
Households
Supply
Demand
Resource,
or Factor
Markets
Product
Market
s
Supply
Demand
Business
Firms
“Labour” – that is, the providing of one’s skills to a skill market – is a Resource, or a Factor of
production. Labour Economics is the economics of the interactions on the left-hand side of this
diagram that occur in these skill markets.
1-3 Markets: Some Greek and A Taxonomy
Some Greek words are used in the economic terminology which describes markets. The Greek
words are: mono, meaning “alone; oligo, meaning few; poly, meaning many; polein, meaning to
sell; and psonein, meaning to buy. These combine to give us mono-poly, a single seller; oligo-poly,
few sellers, and mono-psony, a single buyer. These are commonly used in economics. They could
also be combined to give us olig-psony – few buyers, poly-poly – many sellers, and poly-psony –
many buyers. These latter three are not used, however. We use the word competitive rather than
polypoly or polypsony. Oligopsony isn’t widely studied, although there is no good reason why not.
“Many” and “few” require definition. The definition is operational. “Many” means so many
that no one agent – no single buyer or seller – can have any effect on prices or wages. “Few”
means, therefore, few enough that one agent can have an effect on prices or wages. It’s customary
in Labour Economics to ignore the economics of the few. Here we will deal with markets that have
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only one, or that have many. So Product Markets and skill markets will be competitive on either the
demand or supply side, monopolistic on the demand side, or monopsonistic on the supply side.
This gives the following four possibilities for Demand/Supply in any given market: (1)
competition/competition;
(2)competition/monopoly;
(3)
monopsony/competition,
and
(4)monopsony/monopoly. In addition, since what happens in Product Markets affects outcomes in
Resource Markets, there are two sub-cases for cases (1) and (2): (a) where Supply in the Product
Market is competitive, and (b) where Supply in the Product Market is monopolistic.
[NOTE: The norm in economics is to analyze Product Markets only for cases (1) and (2). This
is curious; there are many examples of monopsony in Product Markets. Cases (3) and (4) are found
in some Product Markets, but it is the convention in micro-economic theory to ignore them. In skill
(labour) markets, however, the norm is to analyze cases (1), (3) and (4), with (2) treated separately.]
Thus there are five cases analyzed in this book. The first is competition/competition in skill
markets, with competition in the Product Market (1-a). This is the basic model, and is explored in
some detail in Chapter 2. The second is competition/competition, but with monopoly in the Product
Market (1-b). This is analyzed in Chapter 3. The third, fourth and fifth all have competition in the
Product Market. The third, monopsony/competition (3), and the fourth, monopsony/monopoly (4) or
what’s known as “bi-lateral monopoly”, are analyzed in Chapter 4 The fifth and last is competition/
monopoly (2). Monopoly in a skill market is a union. Unions are analyzed in Chapter 5.