Economics of Labor
Econ 355
Professor Hedrick
SS 424
Why Study Labor Economics?
• Largely ignored during principles class except for
the minimum wage in microeconomics and wage
flexibility in macroeconomics
• In the U.S., 67% of the population participates in
labor markets.
• A major decision that household members make is
the decision to work (career decisions, the amount
of hours or effort, human capital acquisition,
location)
• One of the most important decisions that
businesses make are employment decisions.
• Income distribution remains a major issue in most
societies. Hence, society and governments are
heavily involved in creating and modifying market
outcomes in labor markets.
• Labor is the input that generates the greatest
income for households. Therefore, it is important
in determining final demands in output markets.
Basic Outline of the Course
• The Economic Approach: positive versus normative
• A descriptive view of labor markets
• The labor market
– Labor demand
• Firm demand for labor
• Demand elasticities
• Quasi-fixed costs
– Labor supply
• The decision to work
• Household production
• Factors affecting the choice of employment
• Issues in labor economics
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Pay and Productivity
Discrimination
Collective Bargaining
Income inequality
Economic Analysis
• The positive economic approach
– Economist as social scientists understanding how society copes
with scarcity
– Economic and the scientific method
• Building models
– An important assumption is that people act rational in pursuit of their
self-interest. Rationality implies consistency and responsiveness to
incentives and leads economists to use incremental or marginal
reasoning.
– The goals of models is ultimately to predict behavior not to be as
realistic as possible
– Example: modeling flight
• Hypothesis testing
– A positive statement is one that can, or at least theoretically could be, put
to the test.
– Economists test theoretical predictions made by models by appealing to
data.
– Data are generally gathered from ongoing behaviors not through an
experimental approach common to many of the natural sciences..
• The normative approach
– While positive economics is fascinating, particularly to
economists, most people are interested in how it can be
used to produce an outcome that they desire.
– This creates a problem for economists. When one
moves from what is (positive economics) to what
should be (normative economics) one ceases to be
objective and one begins moves to making value
judgments.
– Welfare economics, pioneered by the Italian economist,
Vilfredo Pareto, is an attempt to give economists a way
of addressing normative economic questions in a more
generally accepted way.
• Economic efficiency is an attempt to define
economic outcomes in terms of human
satisfaction, well-being, or welfare.
• Voluntary transactions (VT) versus involuntary
transactions (IT).
• Most all economists believe that VT improve
economic welfare because both parties must agree
to the transaction and therefore both must benefit
from the transaction. VT is definitely a positive
sum game.
• IT most likely involve one party who gains and
another who loses. In this case, one must make a
value judgment about whether the transaction
should proceed.
Pareto Efficiency
• If all possible mutually beneficial trades have taken place,
Pareto efficiency has been achieved.
• What happens when a trade reduces someone’s welfare?
Can a unambiguous improvement in welfare still be
identified?
• A change is Pareto-improving if:
– All parties affected by the transaction gain,
– Some gain and no one loses, or
– Some gain and some lose, but those that lose are fully
compensating by those that gain
• In practice, Pareto –improvement is often expanded to
situations where gainers could hypothetically compensate
losers. However, this requires coercive and not voluntary
trade.
• Kaldor-Hicks Criteria
Market Success versus Failure
• In the principles classes, we have learned that
competitive markets encourage voluntary trades
and thus promote economic efficiency.
• More intuitively, competition directs resources to
the production of goods and services that
consumers most highly value and firms are forced
to produce those goods at least possible cost
(compete or be obsolete).
• In certain cases, markets fail to promote efficiency
and the power to coerce, which is inherent in a
government, may be used to increase efficiency.
Market Failures in Goods and Services
Market vs. Labor Markets
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•
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Goods and Services
Markets
Rules of the Game
Public Goods
Externalities
Monopoly Power
Equity
Labor Markets
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•
•
•
Information failures
Transaction Barriers
Distortions in Prices
Non-existence of
Markets
• Equity
• Efficiency loss can be demonstrated in two ways:
– The number of transactions is below or above the
maximum number of voluntary transaction that would
occur in competitive markets with no market failure
– Resources are allocated in a way that marginal social
benefits is not equal to marginal social costs. Therefore
consumer and producer surplus are not maximized.
• Graphical and numerical demonstration of
efficiency loss
The Efficient Level of Output
Price
MSC=Marginal cost
Supply
Value
to
buyers
Cost
to
Seller
Value
to
buyers
Cost
to
seller
MSB or Demand
(value to buyers)
Quantity
0
Value to buyers
is greater than
cost to seller.
Value to buyers
is less than
cost to seller.
Efficient
quantity
Copyright © 2004 South-Western
Figure 8 The Inefficiency of Monopoly
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
0
Monopoly Efficient
quantity quantity
Demand
Quantity
Copyright © 2004 South-Western
Labor Markets
Labor
1
Max
Labor
Wage paid
by Firm
100
1
Min Wage Efficiency
Accepted Gain
by Labor
20
80
2
80
2
40
120
3
60
3
60
120
4
40
4
80
80
5
20
5
100
0
Graphical Presentation
• Supply and demand for labor and
“consumer” and “producer” surplus
revisited
• Monopsony and inefficiency.
Labor Market Failures
• Information failures – ignorance of the “true” costs and
benefits of a transaction. (e.g. hearing protection)
• Transaction barriers – institutional restrictions or ability to
pay considerations that prevent mutually beneficial
transactions from occurring (worker mobility, laws
restricting workers or firms prerogatives).
• Distortions in Prices – prices reflect preferences and
opportunity costs. However, such things as taxes and price
controls may distort prices. (L and I taxes).
• Nonexistence of markets – it may not be possible for
voluntary trades to take place because of the lack of an
established market. (smoke-free work environment)
Government, Market Failure and
Normative Economics
• When markets fail, can government improve welfare?
Good question, the possibility exists in the following
examples.
• Public goods – are goods that are not subject to the exclusion
principle and are non-rival. Therefore, the markets do not have
an incentive to produce public goods in optimal amounts,
• Capital market imperfections – workers cannot afford to move
or invest in human that would like have a good payoff, but they
cannot borrow in the market place because they lack capital.
• Establishing market substitutes – if markets do not exist or do
not function properly, the government can attempt to impose a
solution that mimics what markets would do.
• Efficiency versus equity – even after market
failures are corrected, markets still may not
provide an equitable distribution of income.
– An infinite number of Pareto efficient outcomes
– Equity often requires reductions in efficiency
(taxes and regulations distort market outcomes)
– Initial endowments are important determinants
of the distribution of income, but are the
distribution of these endowments fair?
• When attempting to correct market failures and a
transaction does not unambiguously increase
economic efficiency, value judgments must be
made about the relative importance of gainers and
losers. Therefore, government policy is often
normative.
• The role of the economist is really to identify the
efficiency costs of possible government policies,
so that policymakers/society can be fully informed
of the consequences of their actions.
• Doing so requires an understanding of how
markets work and consumers and businesses
behave and respond, both individually and
collectively.
Economic Theory and Models
• Economics employs the scientific method
• Observation facts → Theories → Data
Gathering → Empirical Testing:
(1) → theory rejected → modify theory
(2) → theory not rejected
• Theories cannot be proved only rejected
• Good theories are those that predict
Econometrics
• Econometrics covers tools used in the empirical
testing of economic theories
• Regression analysis is an important tool that
attempts to test and provide measures of the
relationships between variables within a
theoretical framework
• Linear or straight-line relationships: Y is related,
or caused by X, in the following way:
Y = m + bX
• ‘m’ is the intercept or Y when X=0
• ‘b’ is the slope and measures the ΔY/ ΔX or the
marginal relationship between Y and X
• Different ways of constructing linear relationships
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Goodness of fit
Eye-ball
Minimize residuals
Ordinary least squares – minimize squared residuals
• Intercept, slope and statistical tests…..
• Multiple regression
Y = a + bX + cY + dZ
• Linear versus non-linear lines
• Problems with OLS
– Omitted variable bias
– Multicollinearity
– Heteroskedasticity