Labor Economics
Economics 345
Dr. Pantuosco
Chapter 1 Introductory Notes
Where does labor economics fit into micro and macro?
Micro = the marginal cost curve is effected by the cost of labor. Labor tends to be a
variable cost, therefore, a change in the cost of labor will change the total cost of
producing a good. The average cost curve will change, as will the marginal cost curve.
Holding the demand constant, changes in the marginal cost and average cost curve will
cause changes in the number of goods (and services) produced. Depending on the market,
and the time frame, there will most likely be a change in the price of the good.
Macro = labor is a cost that all businesses must face. Unionization, international trade,
immigration, and wage bargaining power follow national trends. Currently, outsourcing
is on the rise while unions and bargaining (in the private sector) are on the decline. Labor
market pressure affects all workers and all firms. Currently, there is an oversupply of
labor. This glut of workers puts downward pressure on wages. A decrease in wages
pushes the aggregate supply curve to the right. Holding everything else constant, a
decrease in wages causes the amount of goods and services produced (GDP) to increase,
and inflation to fall. Factors to consider are Say’s Law – supply creates its own demand,
and the international implications of American workers accepting lower wages.
Regardless of the approach, micro or macro, labor is a supply side variable. The
difference is whether the individual is analyzing a firm, an industry, a state, or a country.
Labor market topics
Labor productivity
Executive salaries
Athlete salaries
The decision to attend college
Welfare Benefits
Divorce
Immigration
Stimulus Packages –
Infrastructure versus tax rebates
Discrimination
Strikes
Old Approach to Labor
Trends and patterns
New Approach
Statistical Applications
Labor economics is the study of wage determination and employment for the labor
market.
Labor is scarce resource.
Chapter 2
An individual’s decision of whether or not to supply labor. The individual has a choice to
work (which leads to income and consumption) or to have leisure time. Leisure is
necessary for rest, relaxation and to consume the goods that the individual purchases with
his/her income.
There are only 24 a day that a person can use. The individual’s preference for workleisure can be displayed on an indifference curve.
Characteristics of an indifference curve.
 Negative slope
 Convex to the origin diminishing marginal rate of substitution between income and leisure.
 Indifference Map increase to the northeast, they are everywhere.
 Illustration of work- leisure preference workaholics versus leisure lovers
Every individual has a choice between income (labor market activity) and leisure (nonlabor market activity).
Income is desirable for the obvious reasons; in econ terms utility is derived from the
consumption of goods and services U=f(X,Y). Consumption is difficult without income.
Leisure is desirable as well. It is time that can be spent relaxing, or enjoying the
consumption of goods or services. I and L are good goods. However, both goods exhibit
diminishing marginal utility. A person’s first $1,000 (per week) yields more utility than
his/her second $1,000 (per week) and so on. The same is true about leisure. The first hour
(per day) of sitting around the house yields more utility than the second, and so on.
Income
Leisure
As leisure increases the individual is more willing to give up leisure to obtain a little
income. As income increases the individual is willing to give up income to get a little
leisure.
Budget Constraints
Wages and number of hours worked equal income.
Leisure can also be defined as non-market time. Going to school, or raising a family is
not leisure but it is an application of time that is not financially compensated. The
individual is substituting present utility for future utility.
This decision is typically based on household income.
Income
360
240
180
0
24
12
12
24
0
Leisure (per day)
Work (per day)
The decision of the individual is the optimal mix of leisure and work per day. It will
depend on the individual’s taste and preference for leisure and income.
Assuming Consumer A has the following taste and preference for work and leisure which
is displayed by the indifference curve below. Also, assume the person earns $10 per hour.
Income (Y) = wages*hours worked
Y = W*H
H = 24- L
Y = W*(24-L)
Y= -WL + 24L
Therefore, the slope of the budget constraint is –W.
Income
240
120
0
24
12
12
24 Leisure (per day)
0 Work (per day)
The slope of the budget constraint = - w
Slope of the indifference curve =
MUL
MUI
In equilibrium – w = MUL
MUI
If –w is less than MUL The individual will increase their leisure (work less).
MUI
Change in wages.
How does a change in wages effect hours?
There are two effect that work against each other
The substitution effect theorizes that an increase in wages will increase the number of
hours an individual is willing to work. According to the theory, when wages increase cost
of leisure increases, so workers substitute work for leisure.
The income effect theorizes that an increase in wages will decrease the number of hours
an individual is willing to work. According to the theory, a worker only needs so much
income. Let’s say a worker can get by on $800 per week. If the wage rate is $20 per hour
the person will work 40 hours per week, if the wage rate is $50 per hour the person will
only work 16 hours per week. Therefore, an increase in wages causes the number of
hours worked to decrease.
Showing the two effects graphically.
What happens if the wage rate changes?
Income
240
144
120
78
0
12 13
24
24
12 11
0
Leisure (per day)
Work (per day)
The wage rate begins at $10 per hour, $240 per day. At that wage, our fictitious
individual works 12 hours and earns $120 per day.
When the wage rate falls to $6 per hour, $144 per day our fictitious individual works 11
hours a day and earns $66 per day.
The marginal rate of substitution of leisure for income – how does each individual weigh
the value of leisure time versus the income he/she could be earning through work?
There is an optimization principle where the slope of the budget constraint is equal to the
slope of the indifference curve at the optimal levels of work and leisure.
Deriving the labor supply curve. The labor supply curve can be determined by plotting
the optimal points at different wage rates. In essence, each optimal point reveals the
amount of work per individual at each wage rate. The labor supply curve plots the wage
rate and the number of hours each individual will work.
The Labor Supply Curve
Wage
Ls
$10
$6
11
12
Labor hours
When the substitution effect dominates, the labor supply curve is positive upward
sloping, as wages increase the number of hours worked increases.
When the income effect dominates the labor supply curve bends backwards.
In the graphical illustration of the substitution and income effect, we hold relative prices
constant to eliminate the substitution effect. That highlights the income effect. The
substitution effect is the difference between the income effect and the optimal point after
the wage change.
Reservation wage
Wage rate that entices individuals to enter the labor force, the highest wage at which an
individual chooses not to work, or the lowest wage at which an individual would decide
to work.
Factors that effect the reservation wage.
 Welfare or income maintenance benefits
 Unemployment insurance
 Spouses income
 Non labor income
 Cost of commuting
 Other opportunity cost, what the person has to give up to work.
Displayed by the slope of the budget constraint
Mathematical Approach
W is the wage rate
MU is the marginal utility if Leisure increases the marginal utility of leisure decreases.
If Income increases the marginal utility of Income decreases.
Reservation Wage
Income
360
240
0
11 12 14
24
24
13 12 10
0
Leisure (per day)
Work (per day)
The reservation wage must be greater than the slope of the indifference curve. If the
reservation wage is lower than the slope of the indifference curve, a corner solution will
result. In this case, the individual chooses not to work. He or she is happier not working.
Non-Labor income
Spouses income, Investment income, Welfare benefits, Unemployment insurance
Inheritance
Non-wage income
Income
360
Non-labor income
240
$300
$200
0
24
24
0
Leisure (per day)
Work (per day)
Holding everything constant, as non-labor income rises leisure increases and work
decreases. In this example, wages are held constant. This is evident from the slope of the
budget constraint.
More notes below
Winthrop University
College of Business Administration
Labor Economics
Econ 345
Dr. Pantuosco
Spring 2009
Sample Labor Market Questions
Using the work – leisure trade off
The answer to questions a and b should include two graphs, graph one has the work leisure / income relationship, including a budget constraint. Graph two is a labor supply
curve based on the hours worked which are dependent on wages and wage changes.
a. show how an increase in wages impacts labor supply.
b. Show how when wages are low the substitution effect outweighs the income effect,
and when wages are high the income effect outweighs the substitution effect
c. Show how an increase in non-labor income impacts the labor supply decision.
d. How does an increase in non-labor income impact the labor supply curve? Why?
e. Show how an increase in non-labor income impacts the reservation wage.
f. Use the labor –leisure model to explain the decision to retire. Non-labor income should
be measured on the right of the graph.
g. What factors impact the reservation wage?
h. What factors influence non-labor income?
i. Bring in one article that reveals an interesting labor market trend. Be unique. Be ready
to share your article with the class.
Chapter 3
Population, Participation Rates, and the Hours of Work
Population stems from births, deaths, and net immigration
Changes in population stem from changes in these three items above.
Labor Force Participation LFPR = labor force/ Potential labor force
Potential labor force = population - < 16 and institutionalized
- Under 16 year olds are not eligible to work
- Institutionalized individuals are not counted in the labor force population.
Unemployment Rate
Civilian non-institutionalized population (CNIP) unemployed/ labor force
Population – military – institutionalized – under 16s – out of the force
= Non-institutionalized Population
Military Personnel
Labor Force
Out of the Labor Force
The labor force is the sum of the employed and the unemployed.
Employment Rate
Where does employment growth come from?
Change in unemployed, change in labor force, change in population
What changes unemployment rates?
Macroeconomic policies = (interest rates, tax rates, government spending, gdp shocks,
supply side shocks)
What is happening to the natural rate?
It can only be changed by labor supply decisions. Labor demand fluctuates cyclically.
Becker’s Model
Focus on the household as opposed to the individual, and the alternative uses of time.
Time can be sold in the labor market
Used in household production
Used in the consumption of goods in services
Types of Commodities
Goods intensive
Time intensive
Society has become more goods intensive. In an attempt to save time, or use time
differently, households will get their clothes dry cleaned, eat fast food, purchase child
care, cleaning services …..
The more services that become available the more households must choose between what
they want to produce for themselves (time intensive) and what they want to purchase
(goods intensive).
Each person incorporates the theory of comparative advantage in their decision of how to
allocate their time. Should I fix my car, or should I find someone to fix it for me?
Theory of Comparative Advantage individuals should specialize in that productive
endeavor that can be performed with the greatest relative efficiency. Cost benefit analysis
at the individual level. When does it become necessary for an individual to perform their
own tasks? Perhaps when tasks are repetitive.
Becker’s Income Effect when wages rise consumers work less so that they can have
time to consume the goods that they purchase.
Becker’s Substitution Effect the cost of household time rises, and the cost of
consumption time rises. If an individual is at home he/she is giving up the income that
could be obtained from work, and if the individual is on the golf course he/she is giving
up the income from work. Both will be substituted for. A person may stop cooking for
his/her family, or hire someone to mow the lawn. Or a person may fly to a vacation spot
instead of driving, in order to reduce the consumption time.
In the US there have been both effects.
Becker’s Model
Labor is a household decision.
Becker looked at things like divorce to estimate its impact on the labor market
What is the relationship between men’s wages and women’s supply of labor?
Wife
Non labor income rises
Reservation wage rises
Husband
Income effect - work less – it seems as if the income effect would be transferred to the
wife
Substitution effect – work more, make-up for wife’s lost income, the opportunity cost of
staying home rises.
Have higher wages led to more divorce?
Labor Market Trends
Older males are leaving the labor force. Why?
1. Rising Real Wages and Earnings
2. Social Security and Private Pensions
3. Life Cycle Considerations since wages peak at around age 55 after that time workers
leave the labor force.
4. People are living longer
Recent Trend of Re-entry for men between 60-69.
5. Diminishing Returns of family time
6. Poor savings, lost investments
7. Not willing to give up a life style of spending
8. After a life style of staying busy, it is hard to slow down.
Females by age younger women ages 20 through 54 are increasing in the labor force.
Why?
1. Rising Wages
2. Changes in attitudes and work preferences
3. Rising household productivity services available and ease of household chores
4. Declining birthrates
5. Rising divorce rates
6. Job Accessibility
7. Attempts to maintain living standards
Cyclical Changes in the Labor Force Participation Rates
Downturns cause
Increases in the labor force if additional workers are needed to compensate for a
breadwinner losing his job
Decreases if jobs are hard to find a lot of people will not bother looking this is known as
the discouraged worker effect. It could also inspire people to go back to school because
the opportunity cost of school decreases.
Hours of Work per week have declined since the beginning of the 1900’s but held
constant since 1950’s. Why?
1. Fair Labor Standards Act of 1938
2. Higher tax rates
3. Education
4. Salary positions report 40 hours but workers actually put in more time
5. Goods oriented consumers
Chapter 4
Labor Quality: Investing in Human Capital
Human Capital = education, training and migration
Charts and Tables
Income by education level chart. Also find the chart for education level and
unemployment rate. Also look for education level and number of hours worked.
Educated people make more money
Educated people have lower unemployment rates, some would consider it a waste of their
investment if they do not work.
Educated people work longer hours
US students study a lot less than Japanese students.
Cost of Human Capital
 Out of pocket
 Foregone earnings
 Psychic loses
Why are you in college?
Income, employment, power prestige, happiness, status, on he job utility
Present value analysis
PV = - cost of school - the income that you could be earning if you were in the labor
force + incremental earnings (earnings you will receive – earnings you would obtain
without a college degree).
PV = - C - C1 - C2 – C3 + E4 + E5 + … + En
(1+i) (1+i)2 (1+i)3 (1+i)4 (1+i)5
(1+i)n
C = cost out of the pocket and opportunity
E = additional incremental earnings
i = is the discount rate necessary to put every thing into today’s dollars
Who should attend college?
Younger people, why?
Poorer people, why?
People with fewer and lower paying job opportunities upon high school graduation? I.e.
women
This theory predicts that present oriented people are less likely to attend school.
College attendance should decrease with an increase in the cost of tuition.
What about recessions, should that cause college enrollment to rise or fall?
Why do people work when they are in high school or college?
Study time reduces, GPA reduces, quality of college decreases, future income decreases
It is a short term approach to a long term goal.
My theory high school students that work more hours have lower grades, lower GPAs,
maybe lower SAT scores. Why do they work? car, stereo, clothes? Their choice of
college decreases! Students that work in college have lower GPAs, which leads to lower
paying jobs. In the long run, “Who drives the nicer car?”
Ashenfelter and Krueger AER Dec 1994 Twins Study
Why has the college wage premium increased?
The demand for college grads has gone up, technology
The demand for high school grads has gone down, international competition
Great paper summary on page 101!
What matters in determining income?
Choice of school 5 percent
SAT scores 3 percent per 100.
Small college or large college is irrelevant
The presence of a research department or graduate program does not matter.
Most of the difference is a result of the major one chooses.
Find data on percent of majors that are employed in the field they went to school for.
Chart of income by major page 101.
Rates of return for schooling
Rate of
return
Years of school
Other Chapter 4 Issues
On the job training formal versus informal, cost
Criticisms of Human Capital Theory nonwage benefits, the ability problem,
discrimination