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. First we look at the demand for skills. The skills are embedded in people,
and they manifest themselves in the economy through the “labour” of those people. But it makes no
difference whether we call what we’re deriving the demand for “labour” or “hours of skill
provided”. The analysis is identical.
There is one interesting point in the analysis of demand which arises from the fact 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 single “labour market”, is quite plausible, and possibly the norm, if there are
many individual markets for many different skills.
Next we look at short-run labour supply. Each individual faces a given wage from her skill
market. It makes no difference whether the wage comes from a general “labour” market, or a
specific “skill market”. The analysis is identical, with one exception. The exception is the analysis
of secondary workers. There we must treat different workers as facing different wages, so we must
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treat different workers as possessing different skill levels, so their wages come from different skill
markets.
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
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
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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
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.