Chapter 7
The Labor Market, Wages, and
Unemployment
7.1 Introduction
In this chapter, we learn
• how a supply-and-demand model helps us
understand the labor market.
• how labor market distortions like taxes and firing
costs affect employment in the long run.
• how to compute present discounted values.
• why the return to a college education has risen
enormously over the last half-century.
7.2 The U.S. Labor Market
In the U.S. labor market,
• wages account for two-thirds of per capita GDP.
• average wages have grown 2 percent per year for
the last century.
The employment-population ratio:
• Fraction of the civilian population over the age of 16
that is working
• Has been increasing over time
• Decreases during recessions
Ratio of Unemployment to Population in the United States, 1960–2016
The Composition of the U.S. Labor Force, February 2016
The U.S. Labor Market
The unemployment rate
• The fraction of the labor force that is unemployed
A person is unemployed if he or she
• does not have a job that pays a wage or salary,
• has actively looked for a job in the last 4 weeks, and
• is available to work.
The U.S. Unemployment Rate
The Dynamics of the Labor Market
• For most people, periods of unemployment are
relatively short.
• However, a significant fraction remain unemployed
for long periods of time.
• Many countries have developed social safety nets.
• Job creation and job destruction occur each month
in the United States.
7.3 Supply and Demand
Downward-sloping labor demand
• Diminishing marginal product of labor (MPL)
Upward-sloping labor supply curve
• Price of leisure is higher when wages are higher.
The intersection of labor supply and demand
determines the
• level of employment.
• wage rate.
The Labor Market
A Change in Labor Supply
If the government collects a tax on wages
• the labor supply curve shifts left.
• a worker receives less money and supplies less
labor—this applies to any wage.
• To be in equilibrium, firms must raise wages.
An Income Tax at Rate 𝝉
A Change in Labor Demand
If the government creates regulations making it harder
to fire workers,
• firms will demand fewer workers.
• labor demand shifts left,
• wages and employment fall.
• Initially, the unemployment rate rises
• but recovers as discouraged workers drop out of
the labor force.
A Reduction in Labor Demand
Wage Rigidity
Wage rigidity
• Wages fail to adjust after a shock to labor demand or
supply.
What happens if wages do not fall in the above demand
shock example?
• The labor market will not clear; this results in a
larger fall in employment.
A Reduction in Labor Demand with Wage Rigidity
Case Study: Supply and Demand Shocks in the U.S. Labor Market
Rise in employment-population ratio
• Increase in female workers
Supply shocks:
• Changes in social norms
Demand shock:
• Reduced discrimination against women
Rising unemployment in the 1960s and 1970s
• Baby-boomer generation entering the workforce
Supply shock:
• Younger workers have higher unemployment rates.
Different Kinds of Unemployment
Cyclical unemployment:
• Associated with short-run fluctuations in output
The natural rate of unemployment:
• Rate that would prevail with no cyclical
unemployment
• Frictional unemployment:
• Workers between jobs in the dynamic economy
• Structural unemployment:
• Labor market failure to match workers and firms
natural rate
7.4 The Bathtub Model of Unemployment
Bathtub model
• States how employment and unemployment evolve
over time
• (1)
• where
Bathtub Model of Unemployment—1
where (2)
Bathtub Model of Unemployment—2
Solving the model:
• Set the change in unemployment to zero
• Solve the equation for U
Bathtub Model of Unemployment—3
The unemployment rate is the fraction of the labor
force that is unemployed:
To alter the natural rate of unemployment:
• Change the job-finding rate.
• Change the job separation rate.
Policies along these lines can have unintended
consequences.
7.5 Labor Markets around the World
Since 1980:
• Unemployment in Europe is well above the rate in
the United States.
European unemployment has increased because of
• adverse shocks and high oil prices.
• inefficient labor market institutions:
• higher unemployment
• welfare benefits
Unemployment in the United States, Europe, and Japan
Hours Worked per Person
Labor Markets around the World—1
GDP per capita is lower in Europe. Why?
• People work fewer hours.
If working less is voluntary:
• Europeans enjoy leisure more.
• Welfare is likely improved.
If working less is due to distortions in the labor
market:
• This outcome is likely not welfare enhancing.
Case Study: Efficiency of Wages and Henry Ford
Ford instituted a five-dollar-a-day minimum wage.
The theory of efficiency wages:
• Paying a wage greater than the market equilibrium
wage may actually increase profits.
7.6 How Much Is Your Human Capital Worth?
The present discounted value of your lifetime income
is likely greater than $1 million.
Present discounted value:
• The value of money you would need to put in the
bank today to equal a given future value
• Tells how much a future payment or a future flow of
payments is worth today
Present Discounted Value—1
To calculate the value of a stream of equal payments
over a given number of years:
• Arrange the sum of each period’s present
discounted values into a geometric series.
• Use the formula for a sum of a geometric series to
calculate the present discounted value of the stream
of payments.
If a is some number between 0 and 1, then calculating
a geometric series is:
Present Discounted Value—2
The series for $100 initial payment for 20 years:
From the previous slide: If a = 1/(1 + R), then:
Present Discounted Value: Example 1
Letting the interest rate R = 0.10
What is the pdv on $100 over 20 years?
• pdv = $936
Present Discounted Value: Example 2
Assume:
• The average income is $63,000
• No wage growth
• An interest rate of 3 percent
• A lifetime work span of 45 years
The pdv of this stream of payments is $1.59 million.
•
7.7 The Rising Return to Education
The premium to having a college degree:
• Has been rising rapidly over the last forty years
• Far outweighs the forgone wages and tuition costs
The Rising Return to Education
Theoretically,
↑ wages
↑ supply
of college
graduates
↓ wages?
Why hasn’t this happened?
In practice,
↑ wages
↑ supply of
college
graduates
↑ demand
for educated
workers
Change in
demand >
supply
↑ wages?
Understanding the Rising Return to Education
Case Study: Income Inequality
Rising college premium is one cause of rising income
inequality.
Early 1900s
• Most inequality associated with capital income
Recently
• Most inequality associated with salaries and
business income
Income Inequality in the United States and France
7.8 Economic Growth and Income Inequality
So far, we have explored growth as an average income
per person.
Evidence suggests that economic growth may not be
equally distributed.
Economic Growth and Income Inequality
Clicker Question 1
Which of the following is an example of cyclical
unemployment?
a. A worker loses her job because the minimum
wage increases substantially.
b. A worker quits her job to find a better job.
c. A worker is unemployed because the cost of
finding a job in another city is too high.
d. A worker loses her job because the economy
begins to enter a recession.
Clicker Question 1 – Answer
Which of the following is an example of cyclical
unemployment?
a. A worker loses her job because the minimum
wage increases substantially.
b. A worker quits her job to find a better job.
c. A worker is unemployed because the cost of
finding a job in another city is too high.
d. A worker loses her job because the economy
begins to enter a recession.
Clicker Question 2
There is a shock that shifts labor supply or labor
demand to the left. Then, in theory, the unemployment
rate in the long run will
a. depend on whether labor supply or labor demand
is shocked.
b. be unchanged from the level prior to the shock.
c. be higher.
d. be lower.
Clicker Question 2 – Answer
There is a shock that shifts labor supply or labor
demand to the left. Then, in theory, the unemployment
rate in the long run will
a. depend on whether labor supply or labor demand
is shocked.
b. be unchanged from the level prior to the shock.
c. be higher.
d. be lower.
Clicker Question 3
When computing the present discounted value (pdv) of
a future stream of labor income, an increase in the
interest rate will
a. reduce the pdv.
b. increase the pdv.
c. have no change on the pdv.
d. depend on the time path of income.
Clicker Question 3 – Answer
When computing the present discounted value (pdv) of
a future stream of labor income, an increase in the
interest rate will
a. reduce the pdv.
b. increase the pdv.
c. have no change on the pdv.
d. depend on the time path of income.
Clicker Question 4
Suppose oil prices increase. Which of the following is
true?
a. Equilibrium wages are lower.
b. Employment is lower.
c. Both of these choices are correct.
d. None of these choices are correct.
Clicker Question 4 – Answer
Suppose oil prices increase. Which of the following is
true?
a. Equilibrium wages are lower.
b. Employment is lower.
c. Both of these choices are correct.
d. None of these choices are correct.
Clicker Question 5
The rise of the employment-population ratio in the United
States is most likely explained by
a. an increase in female participation in the labor force.
b. a decrease in unemployment benefits.
c. an increase in young people because of the baby boom.
d. improvements to capital.
Clicker Question 5 – Answer
The rise of the employment-population ratio in the United
States is most likely explained by
a. an increase in female participation in the labor force.
b. a decrease in unemployment benefits.
c. an increase in young people because of the baby boom.
d. improvements to capital.
Clicker Question 6
According to the bathtub model of unemployment,
which of the following statements is true if a law
permanently increases only the job finding rate?
a. The natural rate of unemployment will fall.
b. The natural rate of unemployment will rise.
c. The unemployment rate will fall, but the natural
rate of unemployment will be unchanged.
d. The unemployment rate will rise, but the natural
rate of unemployment will be unchanged.
Clicker Question 6 – Answer
According to the bathtub model of unemployment,
which of the following statements is true if a law
permanently increases only the job finding rate?
a. The natural rate of unemployment will fall.
b. The natural rate of unemployment will rise.
c. The unemployment rate will fall, but the natural
rate of unemployment will be unchanged.
d. The unemployment rate will rise, but the natural
rate of unemployment will be unchanged.
Clicker Question 7
A country has a total civilian population (over age 16)
of 300 million. Of this population, 225 million are
employed, 25 million are unemployed, and the
remainder of the population is not in the labor force.
The unemployment rate is
a. 0.083.
b. 0.100.
c. 0.111.
d. 0.150.
Clicker Question 7 – Answer
A country has a total civilian population (over age 16)
of 300 million. Of this population, 225 million are
employed, 25 million are unemployed, and the
remainder of the population is not in the labor force.
The unemployment rate is
a. 0.083.
b. 0.100.
c. 0.111.
d. 0.150.
Clicker Question 8
Suppose a piece of art yields $50 of income each year,
and its income stream does not grow or decline over
time. What is the present discounted value of the
object, assuming it lasts forever? The interest rate is 5
percent.
a. $1,050
b. $10,500
c. $105,000
d. We cannot calculate pdv for an infinite number of
periods.
Clicker Question 8 – Answer
Suppose a piece of art yields $50 of income each year,
and its income stream does not grow or decline over
time. What is the present discounted value of the
object, assuming it lasts forever? The interest rate is 5
percent.
a. $1,050
b. $10,500
c. $105,000
d. We cannot calculate pdv for an infinite number of
periods.
Clicker Question 9
Suppose you open a savings account at the campus
credit union. Into this savings account, you place $100
in savings. The interest rate is 5 percent. The future
value of this account in two years is $110.25.
a. true
b. false
Clicker Question 9 – Answer
Suppose you open a savings account at the campus
credit union. Into this savings account, you place $100
in savings. The interest rate is 5 percent. The future
value of this account in two years is $110.25.
a. true
b. false
Clicker Question 10
Workers in Europe work fewer hours than in the
United States, and thus per capita GDP is lower in
Europe. Because per capita income is lower in Europe,
Europeans are clearly worse off in terms of welfare
than Americans.
a. true
b. false
Clicker Question 10 – Answer
Workers in Europe work fewer hours than in the
United States, and thus per capita GDP is lower in
Europe. Because per capita income is lower in Europe,
Europeans are clearly worse off in terms of welfare
than Americans.
a. true
b. false
Clicker Question 11
Increasing wages beyond the wage rate needed to
retain a worker will definitely decrease a firm’s profit.
a. true
b. false
Clicker Question 11 – Answer
Increasing wages beyond the wage rate needed to
retain a worker will definitely decrease a firm’s profit.
a. true
b. false
Clicker Question 12
The magnitude of the increase in demand for college
graduates does not depend on the size of the shifts in
the market of high school graduates.
a. true
b. false
Clicker Question 12 – Answer
The magnitude of the increase in demand for college
graduates does not depend on the size of the shifts in
the market of high school graduates.
a. true
b. false
Clicker Question 13
If a tax is imposed on labor supply and wages are rigid,
wages and the employment-population ratio will be
lower than the market clearing level after the shock.
a. true
b. false
Clicker Question 13 – Answer
If a tax is imposed on labor supply and wages are rigid,
wages and the employment-population ratio will be
lower than the market clearing level after the shock.
a. true
b. false
Clicker Question 14
The labor demand curve slopes downward because the
marginal product of labor is diminishing as we add
additional labor.
a. true
b. false
Clicker Question 14 – Answer
The labor demand curve slopes downward because the
marginal product of labor is diminishing as we add
additional labor.
a. true
b. false
Clicker Question 15
Bob is not employed by anyone. He does not care about
finding a job and is not searching for a job. Bob is
unemployed.
a. true
b. false
Clicker Question 15 – Answer
Bob is not employed by anyone. He does not care about
finding a job and is not searching for a job. Bob is
unemployed.
a. true
b. false
Clicker Question 16
The unemployment rate in Europe has been higher than that in
the United States during the last two decades because
a. Europeans are not willing to work as much.
b. of the productivity decline in the European economies and
high oil prices in the 1970s.
c. the European system of unemployment insurance is
inefficiently designed.
d. of the combined effect of the inefficient unemployment
insurance system and the productivity slowdown/high oil
prices in the 1970s.
Clicker Question 16 – Answer
The unemployment rate in Europe has been higher than that in
the U.S. during the last two decades because
a. Europeans are not willing to work as much.
b. of the productivity decline in the European economies and
high oil prices in the 1970s.
c. the European system of unemployment insurance is
inefficiently designed.
d. of the combined effect of the inefficient unemployment
insurance system and the productivity slowdown/high
oil prices in the 1970s.
Clicker Question 17
If 21 percent of the unemployed find jobs and 0.9
percent of the employed lose their jobs, the natural
rate of unemployment will be
a. 3.1 percent.
b. 3.5 percent.
c. 4.1 percent.
d. 14.8 percent.
Clicker Question 17 – Answer
If 21 percent of the unemployed find jobs and 0.9
percent of the employed lose their jobs, the natural
rate of unemployment will be
a. 3.1 percent.
b. 3.5 percent.
c. 4.1 percent.
d. 14.8 percent.
Clicker Question 18
You want to deposit $625 in a savings account. If you choose bank A,
your balance will be $756 in two years (bank A pays interest
annually). However, you know that banks B and C also offer savings
accounts: bank B pays an annual interest of 9 percent, while bank C
pays an annual interest of 10 percent. Assuming you plan to keep
your money in the bank for two years, which bank should you
choose? Round to one decimal place.
a. I am indifferent to bank A and bank B.
b. I am indifferent to bank B and bank C.
c. I am indifferent to bank A and bank C.
d. I am indifferent to bank A, bank B, and bank C.
Clicker Question 18 – Answer
You want to deposit $625 in a savings account. If you choose bank A,
your balance will be $756 in two years (bank A pays interest
annually). However, you know that banks B and C also offer savings
accounts: bank B pays an annual interest of 9 percent, while bank C
pays an annual interest of 10 percent. Assuming you plan to keep
your money in the bank for two years, which bank should you
choose? Round to one decimal place.
a. I am indifferent to bank A and bank B.
b. I am indifferent to bank B and bank C.
c. I am indifferent to bank A and bank C.
d. I am indifferent to bank A, bank B, and bank C.
Clicker Question 19
The rise in income inequality in the United States after
1980 is associated with
a. higher taxes for low-income people.
b. lower taxes for high-income people.
c. capital income.
d. salaries and business income.
Clicker Question 19 – Answer
The rise in income inequality in the United States after
1980 is associated with
a. higher taxes for low-income people.
b. lower taxes for high-income people.
c. capital income.
d. salaries and business income.
Clicker Question 20
Globalization helps explain some of the rising wage
inequality in America.
a. true
b. false
Clicker Question 20 – Answer
Globalization helps explain some of the rising wage
inequality in America.
a. true
b. false
Clicker Question 21
The linotte rente is a perpetual bond released by the
French government in 1789. It promises to pay 1000
livres a year until the death of the very last descendant
(essentially, a bond that pays out forever). Assuming
that 1000 livres is worth $1.00, and the discount rate is
3%, what is the PDV of this "forever" bond?
a.
b.
c.
d.
0
infinity
$33.33
$1.00
Clicker Question 21 – Answer
The linotte rente is a perpetual bond released by the French
government in 1789. It promises to pay 1000 livres a year
until the death of the very last descendant (essentially, a bond
that pays out forever). Assuming that 1000 livres is worth
$1.00, and the discount rate is 3%, what is the pdv of this
"forever" bond?
a.
b.
c.
d.
0
infinity
$33.33
$1.00