LABOR
ECONOMICS
LECTURE NOTES
Chapter 1
Introduction
Prepared by: DANIEL MPANDE
[BBA/ECONOMICS_UNZA. MBA FIN_UNZA]
Contents
CHAPTER 1 ...............................................................................................................................2
INTRODUCTION ......................................................................................................................2
1.1
Labor Economics: Some Basic Concepts ..........................................................................2
The Models and Predictions of Positive Economics .....................................................................2
1.2
OVERVIEW OF THE LABOR MARKET .......................................................................4
1.3 The Labor Market: Definitions, Facts, and Trends .................................................................4
1.4 How the Labor Market Works ............................................................................................. 10
The Demand for Labor .............................................................................................................. 11
The Supply of Labor ................................................................................................................. 14
The Determination of the Wage: Equilibrium ............................................................................ 15
1.5 Applications of the Theory .................................................................................................. 17
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CHAPTER 1
INTRODUCTION
Labor economics is simply an economic analysis to the behavior of, and relationship between,
employers and employees. The employment relationship, then, is one of the most fundamental
relationships in our lives, and as such, it attracts a good deal of legislative attention. Knowing the
fundamentals of labor economics is thus essential to an understanding of a huge array of social
problems and programs, both in Zambia and elsewhere.
1.1 Labor Economics: Some Basic Concepts
Labor economics is the study of the workings and outcomes of the market for labor. More
specifically, labor economics is primarily concerned with the behavior of employers and
employees in response to the general incentives of wages, prices, profits, and nonpecuniary
aspects of the employment relationship, such as working conditions. These incentives serve both
to motivate and to limit individual choice. The focus in economics is on inducements for
behavior that are impersonal and apply to a wide range of people.
Positive Economics: is economic theory to analyze ―what is‖;
Scarcity: The pervasive assumption underlying economic theory is that of resource scarcity;
when the demand for a resource at zero price exceeds the supply
Rationality A second basic assumption of positive economics is that people are rational—they
have an objective and pursue it in a reasonably consistent fashion.
The Models and Predictions of Positive Economics
Behavioral predictions in economics flow more or less directly from the two fundamental
assumptions of scarcity and rationality. Workers must continually make choices, such as whether
to look for other jobs, accept overtime, move to another area, or acquire more education.
Employers must also make choices concerning, for example, the level of output and the mix of
machines and labor to use in production.
Economists usually assume that when making these choices, employees and employers are
guided by their desires to maximize utility or profit, respectively.
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However, what is more important to the economic theory of behavior is not the particular goal
of either employees or employers; rather, it is that economic actors weigh the costs and benefits
of various alternative transactions in the context of achieving some goal or other.
Anytime we attempt to explain a complex set of behaviors and outcomes using a few
fundamental influences, we have created a model. Models are not intended to capture every
complexity of behavior; instead, they are created to strip away random and idiosyncratic factors
so that the focus is on general principles.
Normative Economics: is an economic analysis to judge ―what should be.‖
Markets and Values: there is a class of transactions in which there are no losers. Policies or
transactions from which all affected parties gain can be said to be Pareto-improving because they
promote Pareto efficiency.
A transaction can be unanimously supported when:
a. All parties who are affected by the transaction gain.
b. Some parties gain and no one else loses.
c. Some parties gain and some lose from the transaction, but the gainers fully compensate
the losers.
Thus, the role of the labor market is to facilitate voluntary, mutually advantageous transactions.
Hardly anyone would argue against at least some kind of government intervention in the labor
market if the market is failing to promote such transactions.
In neoclassical economics, market failure is a situation in which the allocation of goods and
services by a free market is not Pareto efficient, often leading to a net loss of economic value.
Common Types of Market Failures
Types of market failures include negative externalities, monopolies, inefficiencies in production
and allocation, incomplete information, inequality, and public goods.
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Why do markets fail?
Ignorance: First, people may be ignorant of some important facts and thus led to make decisions
that are not in their self-interest.
Transaction Barriers: Second, there may be some barrier to the completion of a transaction that
could be mutually beneficial.
Externalities: Market failure can also arise when a buyer and a seller agree to a transaction that
imposes costs or benefits on people who were not party to their decision. For us to have
confidence that a particular transaction is a step toward Pareto efficiency, the decision must be
voluntarily accepted by all who are affected by it.
Public Goods: A special kind of externality is sometimes called the ―free rider problem.‖
Price Distortion: A special barrier to transaction is caused by taxes, subsidies, or other forces
that create ―incorrect‖ prices. Prices powerfully influence the incentives to transact, and the
prices asked or received in a transaction should reflect the true preferences of the parties to it.
1.2 OVERVIEW OF THE LABOR MARKET
Every society—regardless of its wealth, its form of government, or the organization of its
economy—must make basic decisions. It must decide what and how much to produce, how to
produce it, and how the output shall be distributed. These decisions require finding out what
consumers want, what technologies for production are available, and what the skills and
preferences of workers are; deciding where to produce; and coordinating all such decisions. The
process of coordination involves creating incentives so that the right amount of labor and capital
will be employed at the right place at the required time.
The market that allocates workers to jobs and coordinates employment decisions is the labor
market.
1.3 The Labor Market: Definitions, Facts, and Trends
Every market has buyers and sellers, and the labor market is no exception: the buyers are
employers, and the sellers are workers. A labour market is the place where workers and
employees interact with each other. In the labour market, employers compete to hire the best, and
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the workers compete for the best satisfying job. A labour market in an economy functions with
demand and supply of labour.
The Labor Force and Unemployment
Labor force refers to all those over 15 years of age who are employed, actively seeing work,
or expecting recall from a layoff. Those in the labor force who are not employed for pay are
the unemployed. People who are not employed and are neither looking for work nor waiting
to be recalled from layoff by their employers are not counted as part of the labor force. The
total labor force thus consists of the employed and the unemployed.
LF = labor force = U + E
There are four major flows between labor market states:
1. Employed workers become unemployed by quitting voluntarily or being laid off (being
involuntarily separated from the firm, either temporarily or permanently).
2. Unemployed workers obtain employment by being newly hired or being recalled to a job
from which they were temporarily laid off.
3. Those in the labor force, whether employed or unemployed, can leave the labor force by
retiring or otherwise deciding against taking or seeking work for pay (dropping out).
4. Those who have never worked or looked for a job expand the labor force by entering it,
while those who have dropped out do so by reentering the labor force.
Labor force participation rate: is the number of persons in the labor force as a percentage of
the working-age population (those aged 16 and above).
Unemployment is a term referring to individuals who are employable and actively seeking a
job but are unable to find a job.
Unemployment rate: The ratio of those unemployed to those in the labor force
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Transitions in the LM
Sectors, Industries and Occupations
An interesting lens to analyse the labour market is in terms of the type of activity/work
individuals are involved with.
 At the highest level we can divide economic activity into three sectors: primary, secondary
and tertiary.
o Primary sector: extractive processes that create or harvest raw materials, eg
forestry, fishing, farming, mining
o Secondary sector: where these resources are processed. Sometimes we refer to
this as manufacturing
o Tertiary sector: retail/delivery of the above and other services
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 At a lower level we have industries and occupations.
Industries are comprised of firms doing similar work, for e.g. the textiles industry.
Within industries we have occupations, which are jobs or sets of tasks within the firms of
an industry.
So, again, like with LFP we have a nested structure:
o Sector>Industry>Occupation
o For eg, weaving is an occupation in the textiles sector, which in the secondary
sector.
More definitions: wealth, income, earnings, wages
•
There are several terms we use to describe the monetary returns to work and other assets.
•
Wealth is a stock or accumulation of assets. A common measure is net worth.
•
Income is a flow variable representing a change in wealth of a particular rate. Income in
turn can be broken down by source, for example income from a primary job, interest
income, rental income etc.
•
Earnings are the income someone receives from paid work. Earnings can be from selfemployed work or from working from someone else.
•
Wages are the earnings rate per unit of time (eg K120 per hour).
•
Sometimes we will use wages and earnings interchangeably
The term wages refers to the payment for a unit of time, whereas earnings refer to wages
multiplied by the number of time units (typically hours) worked. Thus, earnings depend on both
wages and the length of time the employee works.
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Wages: Nominal vs real
The wage rate is the price of labour per working hour, which could be measured in nominal
and/or real terms:
•
Nominal wage –what workers get paid per hour in current dollars/kwacha.
•
Real wages –nominal wages divided by some measure of prices (usually the consumer
price index –CPI).
How to calculate the CPI and inflation rate:
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First we need to know how much of each good were purchased each year and what
the prices were:
1984 Price
1984 Quantity
Hamburger
$.80
40
Jeans
$24
1
Movie Ticket
$5.00
4
Then find total expenditure by multiplying price times quantity and adding them:
Expenditure = (.80 x 40) + (24 x 1) + (4 x 5) = $75
$32 + $24 + $20 = $75
Now, 20 years later, we have new prices:
2004: Hamburger
Jeans
Movie Ticket
$1.20
$30
$7.00
Assume that the market basket (the amount purchased) stays the same in 2004 as
it was in 1984 and the only thing that’s changed are prices. Now what does that
market basket cost in 2004? Use 1984 prices and 2004 quantities.
($1.20 x 40) + ($30 x 1) + ($7 x 4) = $106
$48 + $30
+ $28 = $106
To find the CPI in any year, divide the cost of the market basket in year t by the
cost of the same market basket in the base year.
The CPI in 1984 = $75/$75 x 100 = 100 The CPI is just an index value and it is
indexed to 100 in the base year, in this case 1984.
To find the CPI in 2004 take the cost of the market basket in 2004 and compare it
to the same basket in 1984:
CPI in 2004 = $106/$75 x 100 = 128.0
Now we can calculate the inflation rate between 1984 and 2004:
(128 – 100) /100 = 28/100 = 28%
So prices have risen by 28% over that 20 year period. If the period was 1984 to
1985 we would say that inflation was 28% in 1985.
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Real wages help estimates the real values of wages/earnings over time and expresses nominal
wages in terms of a standardised bundle of goods one can obtain, eg, if inflation is high, one can
only get a relatively low bundle of good and vice versa.
Another distinction can be drawn between gross and net wages
•
Gross are the wages before any deductions and tax
•
Net is the amount you get on payday, which has deductions and income tax automatically
taken out. Deductions could be for medical aid or pension for example
•
Why is the distinction important?
 Effective tax rate
 Incidence of the tax
1.4 How the Labor Market Works
The model of the labor market begins and ends with an analysis of the demand for and supply of
labor. On the demand side of the labor market are employers, whose decisions about the hiring
of labor are influenced by conditions in all three markets. On the supply side of the labor market
are workers and potential workers, whose decisions about where (and whether) to work must
take into account their other options for how to spend time.
•
Firms demand for labour from different labour markets
•
Workers supply their labour services
This model inherently focusses on the level of employment and the wage rate. However, there
are other factors in the terms of employment (such as working conditions, hours, bonuses, etc)
and the levels of employment that are also relevant.
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The Demand for Labor
Firms combine various factors of production—mainly capital and labor—to produce goods or
services that are sold in a product market. Their total output and the way in which they combine
labor and capital depend on three forces:
i.
Product demand
ii.
The amount of labor and capital they can acquire at given prices.
iii.
The choice of technologies available to them.
When we study the demand for labor, we are interested in finding out how the number of
workers employed by a firm or set of firms is affected by changes in one or more of these three
forces.
We start with firms, that combine capital (K), labour (L) and a technology set (T) to produce.
They also face a market-level demand (QD) for their product.
The cost of labour is wages (W) and the cost of capital is a representative price or rental rate (rk).
The quantity of labour a firm demands is inversely related to the wage rate; higher wages lead
firms to demand less labour
LD = f (W, QD, T, rk)
We will talk about the relationships between the variable
Labor Demand Schedule for a Hypothetical Industry
Wage Rate (K) Desired Employment Level
3.00
250
4.00
190
5.00
160
6.00
130
7.00
100
8.00
70
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Labor Demand Curve (MOVEMENT ALONG CURVE)
What would happen to the quantity of labor demanded if the wage rate were increased?
1. First, higher wages imply higher costs and, usually, higher product prices. Because
consumers respond to higher prices by buying less, employers would tend to reduce their
levels of output and employment (other things being equal). This decline in employment
is called a scale effect—the effect on desired employment of a smaller scale of
production.
2. Second, as wages increase (assuming the price of capital does not change, at least
initially), employers have incentives to cut costs by adopting a technology that relies
more on capital and less on labor. Desired employment would fall because of a shift
toward a more capital-intensive mode of production. This second effect is termed a
substitution effect, because as wages rise, capital is substituted for labor in the
production process.
What happens to labor demand when one of the forces other than the wage rate
changes?(SHIFT IN DEMAND CURVE)
i.e Change in product demand.
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First, suppose that demand for the product of a particular industry were to increase, so that at any
output price, more of the goods or services in question could be sold. Suppose in this case that
technology and the conditions under which capital and labor are made available to the industry
do not change. Output levels would clearly rise as firms in the industry sought to maximize
profits, and this scale (or output) effect would increase the demand for labor at any given wage
rate. (As long as the relative prices of capital and labor remain unchanged, there is no
substitution effect.)
i.e Change in Capital price.
First, when capital prices decline, the costs of producing tend to decline. Reduced costs stimulate
increases in production, and these increases tend to raise the level of desired employment at any
given wage. The scale effect of a fall in capital prices thus tends to increase the demand for labor
at each wage level.
The second effect of a fall in capital prices would be a substitution effect, whereby firms adopt
more capital-intensive technologies in response to cheaper capital. Such firms would substitute
capital for labor and would use less labor to produce a given amount of output than before. With
less labor being desired at each wage rate and output level, the labor demand curve tends to shift
to the left.
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A fall in capital prices, then, generates two opposite effects on the demand for labor. The scale
effect will push the labor demand curve rightward, while the substitution effect will push it to the
left.
The demand for labor can be analyzed on three levels; particular firm, industry demand curve
and market demand curve
The Supply of Labor
Workers on the other hand supply their labour. The amount of labour supplied increases with the
wage offered. So there is a positive relationship between wages and labour supply.
Ls = f(W, other factors e.g work environment)
As with demand curves, each supply curve is drawn holding other prices and wages constant. If
one or more of these other prices or wages were to change, it would cause the supply curve to
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shift. As the salaries of insurance agents rise, some people will change their minds about
becoming paralegals and choose to become insurance agents.
The Determination of the Wage: Equilibrium
The wage that prevails in a particular labor market is heavily influenced by labor supply and
demand, regardless of whether the market involves a labor union or other nonmarket forces.
•
So we have a system where both LD and Ls depend on the W.
•
Lets assume they both react to wage changes in a linear way. We will graph with W on
the y-axis and Q on the x-axis:
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The Market-Clearing Wage: The wage rate at which demand equals supply
A couple of things to understand about the diagram:
•
Ls and Ld are lines made up of combinations of W and Q
•
If W changes, this will lead to a movement along a given line. This is the standard way
we analyse labour using equilibrium – labour reacts to price.
•
Other factors mentioned before will come into play in a more advanced setting
The market-clearing wage,
, thus becomes the going wage that individual employers and
employees must face. In other words, wage rates are determined by the market and ―announced‖
to individual market participants. Figure above graphically depicts market supply and demand in
panel (a), along with the supply and demand curves for a typical firm (firm A) in that market in
panel (b). All firms in the market pay a wage of
, and total employment of L equals the sum of
employment in each firm.
A couple of things to understand about this theory:
•
Holding (T,
,)
constant, a sufficient number of jobs can always be created by letting the
wage fall far enough.
•
It doesn’t say anything about if this is feasible or realistic.
•
Its attraction is that it a simple tool for modeling the labour market.
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1.5 Applications of the Theory
Who Is Underpaid and Who Is Overpaid?
Above-Market Wages We shall define workers as overpaid if their wages are higher than the
market-clearing wage for their job. Because a labor surplus exists for jobs that are overpaid, a
wage above market has two implications;
i.
First, employers are paying more than necessary to produce their output (they pay WH
instead of We); they could cut wages and still find enough qualified workers for their job
openings.
ii.
Second, more workers want jobs than can find them (Y workers want jobs, but only V
openings are available). If wages were reduced a little, more of these disappointed
workers could find work.
A wage above market thus causes consumer prices to be higher and output to be smaller than is
possible, and it creates a situation in which not all workers who want the jobs in question can get
them.
Below-Market Wages Employees can be defined as underpaid if their wage is below marketclearing levels. At below-market wages, employers have difficulty finding workers to meet the
demands of consumers, and a labor shortage thus exists. They also have trouble keeping the
workers they do find. If wages were increased, output would rise and more workers would be
attracted to the market.
Thus, an increase would benefit the people in society in both their consumer and their worker
roles.
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Figure below shows how a wage increase from WL to We would increase employment from V to
X (at the same time wages were rising).
TO BE CONTINUED………….
Prepared by: DANIEL MPANDE
[BBA/ECONOMICS_UNZA. MBA FIN_UNZA]
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