Chapter 9
The Labor Market and
Wage Rates
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 9 / THE LABOR MARKET AND WAGE RATES
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
Labor Markets In Perspective




Labor Markets differ in an important way from the other
markets we’ve considered so far in this book
 Firms need resources to make goods and services
We can identify three general categories of resource
markets
 Markets for capital
 Markets for land
 Markets for labor
Labor is different from other things that are traded
 Sellers of labor care about factors in the work place
Another feature of labor is the meaning of the price in this
market
 Wage rate
Lieberman & Hall; Introduction to Economics, 2005
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Figure 1: Product and Factor
Markets
Product Markets
Demand for Goods
and Services
S
D
Households
Supply of Goods
and Services
Firms
S
Supply of
Resources
D
Demand for
Resources
Factor Markets
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Defining a Labor Market

How broadly or narrowly we define a
market depends on the specific questions
we wish to answer
 Broadly defined markets may look at markets
that draw on labor from all over the world
 Narrowly defined markets may look at markets
that draw on labor on a very localized level
Lieberman & Hall; Introduction to Economics, 2005
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Competitive Labor Markets

Market with many indistinguishable sellers
of labor and many buyers
 Involves no barriers to entry or exit
 Perfectly competitive labor markets must
satisfy three conditions
• Great many buyers (firms) and sellers (households) of
•
•
labor in market
All workers in market appear the same to firms
No barriers to entering or leaving labor market
Lieberman & Hall; Introduction to Economics, 2005
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Competitive Labor Markets and The
Equilibrium Wage

Wage rate determined like the price of other competitive markets:

The labor demand curve in any labor market slopes downward because
a rise in the wage rate
 Supply and demand
 1) increases firms’ costs, causing them to decrease production and employ


fewer workers
2) increases the relative cost of labor from that market, causing firms to
substitute other inputs, such as capital or other types of labor
The labor supply curve in any labor market slopes upward because a
rise in the wage rate
 1) induces some of those not currently working to seek work
 2) attracts some of those who are currently working in other labor markets

The forces of supply and demand will drive a competitive labor market to
its equilibrium point—the point where the labor supply and labor demand
curves intersect
Lieberman & Hall; Introduction to Economics, 2005
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Figure 2: A Competitive Labor Market
Hourly
Wage
LS
$12
LD
10,000
Lieberman & Hall; Introduction to Economics, 2005
Number of
Workers
7
Why Do Wages Differ?
 Significant
inequality exists in wage
rates
 Among different occupations
 Among and within occupations in U.S.
labor market
 Wage
inequality is persistent
 Both highest and lowest paid
occupations have been so for decades
Lieberman & Hall; Introduction to Economics, 2005
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An Imaginary World

To understand why wages differ in the real
world, let’s start by imagining an unreal world
 Except for differences in wages, all jobs are
equally attractive to all workers
 All workers are equally able to do any job
 All labor markets are perfectly competitive

In such a world, we would expect every
worker to earn an identical wage in long-run
Lieberman & Hall; Introduction to Economics, 2005
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An Imaginary World

Figure 3 shows two different labor markets
that initially have different wage rates
 In our imaginary world, could this diagram
describe long-run equilibrium in these markets?
• No

As these shifts occur, market wage rate of
elementary school teachers will rise and that
of systems analysts will fall
Lieberman & Hall; Introduction to Economics, 2005
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Figure 3: Disappearing Wage
Differentials
(a)
Hourly
Wage
(b)
Hourly
Wage
S
L2
S
L1
S
S
L1
L2
B
$30
A'
25
$25
A
20
LD
Number of Elementary
School Teachers
Lieberman & Hall; Introduction to Economics, 2005
B'
LD
Number of Computer
Systems Analysts
11
An Imaginary World

When will the entry and exit stop?
 When there is no reason for an elementary school teacher to want to
be a systems analyst
• When both labor markets are paying same wage rate



Long-run adjustments will occur even if no one actually
switches jobs
Changes will continue until—at points A’ and B’—the longrun wage rate is equal in both markets
Take any one of these assumptions away, and equal-wage
result disappears
 Tells us where to look for sources of wage inequality in real world
• A violation of one or more of our assumptions
Lieberman & Hall; Introduction to Economics, 2005
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Compensating Differentials



In our imaginary world, all jobs were equally
attractive to all workers
In real world, jobs differ in hundreds of ways that
matter to workers
When one job is intrinsically more or less attractive
than another
 Can expect wages to differ by a compensating wage
differential
• Difference in wage rates that makes two jobs equally attractive to
workers
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Nonmonetary Job Characteristics

When evaluating a career, whether you are
aware of it or not, you are evaluating
hundreds of nonmonetary job characteristics,
including
 Risk of death or injury
 Cleanliness of work environment
 Prestige you can expect in your community
 Amount of physical exertion required
 Degree of intellectual stimulation
 Potential of advancement
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Nonmonetary Job Characteristics


You will also think about geographic location of job and
characteristics of the community in which you would live and
work
 Weather
 Crime rates
 Pollution levels
 Transportation system
 Cultural amenities
Nonmonetary characteristics of different jobs give rise to
compensating wage differentials
 Jobs considered intrinsically less attractive will tend to pay higher
wages, other things being equal
Lieberman & Hall; Introduction to Economics, 2005
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Nonmonetary Job Characteristics

What about unusually attractive jobs?
 These jobs will generally pay negative compensating
differentials


Different people have different tastes for working
and living conditions
Cannot use our own preferences to declare a job
as less attractive or more attractive
 Or to decide which jobs should pay a positive or negative
compensating differential
• Rather, when labor markets are perfectly competitive

Entry and exit of workers automatically determines compensating
wage differential in each labor market
Lieberman & Hall; Introduction to Economics, 2005
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Nonmonetary Job Characteristics

Compensating wage differentials are one reason
most economists are skeptical about idea of
comparable worth
 Holds that a government agency should determine skills
required to perform different jobs and mandate wage
differences needed between them

Economists generally prefer policies to increase
competition and eliminate discrimination
 So that the market itself can determine comparable worth
Lieberman & Hall; Introduction to Economics, 2005
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Cost of Living Differences

Differences in living costs can cause
compensating wage differentials
 Areas where living costs are higher than average
will tend to have higher than average wages
• To compensate for the higher cost of living
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Differences in Human Capital
Requirements

All else equal, jobs that require more education and training will be less
attractive
 In order to attract workers, these jobs must offer higher pay than other jobs
that are similar in other ways, but require less training

Differences in human capital requirements can give rise to
compensating wage differentials
 Jobs that require more costly training will tend to pay higher wages, other
things equal


Compensating differentials explain much of the wage differential
between jobs requiring college degrees and requiring only a high school
diploma
The idea of compensating wage differentials dates back to Adam Smith
 First observed that unpleasant jobs seem to pay more than other jobs that
require similar skills and qualifications
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Differences In Ability



Not everyone has the intelligence needed to perform well at
any job
Scientific discoveries and technological advances have
increased not only skill requirements of many jobs
 But also abilities needed to acquire those skills
In general, those with greater ability to do a job well—based
on their talent, intelligence, motivation, or perseverance—
will be more valuable to firms
 Firms will be willing to pay them a higher wage rate
• Beyond any compensating differential for their human capital investment
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The Economics of Superstars

Why was owner of Texas Rangers willing to pay $25 million per year to
have Alex Rodriguez play for his team?
 Immediate answer


• Because Rodriguez is so good
When we try to explain extremely high wage rates of these superstars
based on their exceptional abilities alone, we confront a puzzle
The very top writers, rock stars, comedians, talk-show hosts, and movie
directors all earn wage premiums that seem vastly out of proportion to
their additional abilities
 Why?

Explanation in all these cases is based on ability
 And also by exaggerated rewards market bestows on those deemed the
best or one of the best in a field
Lieberman & Hall; Introduction to Economics, 2005
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The Economics of Superstars



If most people rank recent mystery novels in the same
order, then the best will sell millions of copies, second best
will sell hundreds of thousands, and third best might sell
only thousands
 Even though all three novels might be very close in quality
A publisher will earn ten times more revenue selling the best
novel (compared to the second best), and ten times more
revenue selling the second best (compared to the third
best), and so on
Same thing happens in markets for athletes, rock concerts,
action movies, and news broadcasters
 But phenomenon is not limited to media markets or media stars
Lieberman & Hall; Introduction to Economics, 2005
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Barriers to Entry


In some labor markets, barriers keep out would-be
entrants
 Resulting in higher wages in those markets
Since barriers to entry help maintain high wages for
those protected by the barriers—those who already
have jobs in the protected market
 Should not be surprised to find that in almost all cases, it
is those already employed who are responsible for
erecting barriers
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Occupational Licensing


In many labor markets, occupational licensing laws keep out potential
entrants
American Medical Association (AMA) is perhaps the strongest example
of occupational licensing as a barrier to entry
 Professional organization to which almost half of American physicians




belong
Much of AMA’s activity has been designed to decrease supply of doctors
AMA has also increased demand for physicians’ services by preventing
nonphysicians from competing
In late 1980’s, rising health care costs led to increased public scrutiny of
AMA, and its anticompetitive practices came under heavy attack
Economists see AMA primarily as an instrument to maintain high
incomes for doctors
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Figure 4: The Market for Physicians
Physicians'
Salaries
2. AMA restrictions
on the supply of
physicians move
the market here.
S
L2
S
L1
C
W3
W2
W1
B
A
D
L2
D
L1
1. Without AMA activities
to increase salaries,
equilibrium is here, at
wage rate W1.
Lieberman & Hall; Introduction to Economics, 2005
3. Other policies to
increase demand
for physicians
move the market
here, at final
wage rate W3.
Number of Physicians
25
Union Wage Setting


A labor union represents collective interests of its
members
Major objective of a union is to raise its members’
pay
 Higher union wage is contrary to interests of employer—
so why does employer agree?
• Because union has power to strike

In a competitive labor market, a union—by raising
the wage firms must pay—decreases total
employment in the union sector
 This, in turn, causes wages in non-union sector to drop
 Result is a wage differential between union and nonunion wages
Lieberman & Hall; Introduction to Economics, 2005
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Figure 5(a): Union Wage Differentials
(a)
Wage
2. A union wage of for long-haul truckers of
W2 creates an excess supply of workers.
W2
W1
LS
A'
A
1. With no labor union, both longand short-haul truckers earn the
same wage rate, W1.
LD
250,000
350,000
300,000
Number of Long-haul Truckers
Lieberman & Hall; Introduction to Economics, 2005
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Figure 5(b): Union Wage Differentials
(b)
Wage
3. Unemployed long-haul truckers move to the
nonunion short-haul market, and the labor
supply curve shifts rightward . . .
S
L1
S
L2
B
W1
W3
B'
LD
200,000
225,000
Lieberman & Hall; Introduction to Economics, 2005
4. pushing the short-haul wage
rate down to W3.
Number of Shorthaul Truckers
28
Union Wage Setting

Unions still maintain a significant, though declining,
presence in many industries
 Such as automobiles, steel, coal, construction, mining, and trucking
 Certainly responsible for at least some of the higher wages earned in
those industries



Full effect of unions on labor markets is much more complex
Many of the features of modern work that we take for
granted today originated in union struggles with
management
 Such as paid vacations and overtime pay
Unions can raise workers morale and reduce labor turnover
 Through grievance procedures and other forms of communications
with management
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Discrimination and Wages


Discrimination occurs when members of a group of
people have different opportunities because of
characteristics that have nothing to do with their
abilities
First step in understanding economics of
discrimination is to distinguish two words that are
often confused
 Prejudice

• Emotional dislike for members of a certain group
Discrimination
• Restricted opportunities offered to such a group
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Employer Prejudice


When you think of job discrimination, your first
image might be a manager who refuses to hire
members of some group because of pure prejudice
 Such as African-Americans or women
May surprise you to learn that economists generally
consider employer prejudice one of the least
important sources of labor market discrimination
 When prejudice originates with employers, market forces
work to discourage discrimination and reduce or
eliminate any wage gap between favored and unfavored
group
Lieberman & Hall; Introduction to Economics, 2005
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Employee and Customer Prejudice

What if workers—rather than employers—are prejudiced?
 In a competitive output market, non-discriminating firm will be forced
out of business
• Cannot count on the market to solve the problem


Same argument applies if the prejudice originates with firm’s
customers
When prejudice originates with firm’s employees or its
customers
 Market forces may encourage, rather than discourage, discrimination
• Can lead to a permanent wage gap between favored and unfavored
groups
Lieberman & Hall; Introduction to Economics, 2005
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Figure 6: Employer Discrimination and
Wage Rates
Sector A
(Discriminating)
Sector B
(Nondiscriminating)
Wage
Wage
S
L2
W3
W1
E'
S
L1
S
L1
S
L2
F
W1
E
W2
LD
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005
F'
LD
Number of Workers
33
Statistical Discrimination

Suppose you are in charge of hiring 10 new employees at
your firm
 Young married women in your industry are twice as likely to quit their
jobs within two years than men and those that quit are very costly to
your firm
 20 people apply for 10 positions—half men and half women
• Whom will you hire?


If your sole goal is to maximize the firm’s profit
 You will hire men
Even if there isn’t a trace of prejudice in you, in the firm’s
employees, or in its customers, profit maximization may still
dictate hiring the men
Lieberman & Hall; Introduction to Economics, 2005
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Statistical Discrimination



When individuals are excluded from an activity
based on the statistical probability of behavior in
their group
 Rather than their personal characteristics
Some observers have suggested that statistical
discrimination is often a cover for prejudice
According to critics of the statistical discrimination
theory, the negative behavior of a favored group is
rarely considered by employers
Lieberman & Hall; Introduction to Economics, 2005
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Dealing With Discrimination


Discrimination due to pure employer prejudice is unlikely to
have much of an impact on labor markets
For other types of discrimination market incentives work in
the opposite way, leading to a permanent and stubborn
problem
 Such as statistical discrimination or discrimination due to worker or
consumer prejudice
• In these cases, many economists and other policy makers believe that
government action is needed


Some favor affirmative action programs
Others favor stricter enforcement of existing antidiscrimination laws and
stiffer penalties when discriminatory hiring occurs
 Both approaches to policy force all firms to bear costs of
nondiscriminatory hiring
Lieberman & Hall; Introduction to Economics, 2005
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Discrimination and Wage Differentials



Consider the black-white differential for men
Several studies suggest that if we limit comparisons to whites and
blacks with same educational background, geographic location, and, in
some cases, same ability (measured by a variety of different tests), 50%
or more of the earnings difference disappears
In addition to job-market discrimination, there is pre-market
discrimination
 Occurs before an individual enters labor market

• Such as unequal treatment in education and housing
For women, as well as blacks and other minorities, differences in skills
and experience can be the result of lower wages
 Since women know they will earn less than men and will have more trouble
advancing on the job
• They have less incentive to invest in human capital and to stay in labor force
Lieberman & Hall; Introduction to Economics, 2005
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Discrimination and Wage Differentials


In the end, we do not know nearly as much about the impact
of discrimination on wages as we would like to know
 But research is proceeding at a rapid pace
As we’ve seen, data must always be interpreted with care
 In measuring impact of job market discrimination on earnings
• Wage gap between two groups gives an overestimate

Since it fails to account for differences in skills and experience
 However, comparing only workers with similar skills and experience
leads to an underestimate
• Since some of the differences are themselves caused by
discrimination—both in the job market and outside of it
Lieberman & Hall; Introduction to Economics, 2005
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Figure 7: Vicious Cycle of
Discrimination
Current Job
Discrimination
Pre-market
Discrimination
Lieberman & Hall; Introduction to Economics, 2005
Lower Wage
Lower Human
Capital
Investment
Unemployment
Lower Skill Level
Less Job
Experience
39
Using The Theory: The Minimum Wage



Minimum wage law…makes it illegal to hire a
worker for less than a specified wage
 In any labor market covered by the law
Most people think about the minimum wage as a
means to increase living standards for the lowest
paid workers, and their analysis stops there
But minimum wage creates a wage differential
among the least-skilled workers, depending on the
industry in which they work
 By raising wages rates in covered industries, and
lowering them in uncovered industries
Lieberman & Hall; Introduction to Economics, 2005
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Figure 8(a/b): The Minimum Wage
(a)
(b)
Unskilled Labor
Covered by Law
Unskilled Labor Not
Covered by Law
Hourly
Hourly
A
minimum
wage
raises
Wage
Wage
pay, but decreases jobs
in the covered sector.
$5.15
4.00
LD
A
N1
$4.00
3.00
S
L2
LS
A'
N2
S
L1
B
B'
LD
Some who can't
find work go to
the uncovered
sector, lowering
wages there.
N3
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005
Number of Workers
41
Figure 8(c): The Minimum Wage
(c)
Hourly
Wage
$24.00
20.00
Skilled Labor
LS
C'
C
D
L2
As capital is substituted for
unskilled labor, demand for
skilled workers goes up,
raising the skilled wage rate.
D
L1
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005
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Using The Theory: The Minimum Wage

Only one group of workers in which everyone
benefits: skilled workers
 Should come as no surprise that for many decades the
most vocal advocates of raising the minimum wage have
been labor unions
• Membership is disproportionately made up of skilled workers

What do economists think about the minimum
wage?
 Most regard it as an inefficient policy for helping poor
working families
Lieberman & Hall; Introduction to Economics, 2005
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Using The Theory: The Minimum Wage

You might think that economists would
overwhelmingly oppose any increase in minimum
wage
 But that is not the case
• Those who favored an increase in minimum wage tended to
believe the effect on unemployment was much smaller than those
who opposed an increase
• Others may believe that higher unemployment is more likely to
influence policy in a direction they favor

The minimum wage, like most issues of public
policy, is not as simple as it appears
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