CHAPTER 4
“Order is not pressure which is
imposed on society from
without, but an equilibrium
which is set up from within.”
-Jose Ortega y Gasset
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• Labor market equilibrium coordinates the desires of firms
and workers, determining the wage and employment
observed in the labor market.
• Market types:
o Monopsony: one buyer of labor
o Monopoly: one seller of labor
• These market structures generate unique labor market
equilibria.
4-2
Equilibrium in a Single
Competitive Labor Market
• Competitive equilibrium occurs when supply equals
demand, generating a competitive wage and
employment level.
• It is unlikely that the labor market is ever in an
equilibrium, since supply and demand are dynamic.
• The model suggests that the market is always moving
toward equilibrium.
4-3
Efficiency
• Pareto efficiency exists when all possible gains from
trade have been exhausted.
• When the state of the world is (Pareto) Efficient, to
improve one person’s welfare necessarily requires
decreasing another person’s welfare.
• In policy applications, ask whether a change can make
any one better off without harming anyone else. If the
answer is yes, then the proposed change is said to be
“Pareto-improving”.
4-4
Equilibrium in a Competitive Labor
Market
Dollars
S
P
w*
Q
D0
EL
E*
EH
Employment
The labor market is in equilibrium
when supply equals demand; E*
workers are employed at a wage
of w*. In equilibrium, all persons
who are looking for work at the
going wage can find a job. The
triangle P gives the producer
surplus; the triangle Q gives the
worker surplus. A competitive
market maximizes the gains from
trade, or the sum P + Q.
4-5
Competitive Equilibrium
Across Labor Markets
• If workers were mobile and entry and exit of workers
to the labor market was free, then there would be a
single wage paid to all workers.
• The allocation of workers to firms equating the wage
to the value of marginal product is also the
allocation that maximizes national income (this is
known as allocative efficiency).
• The “invisible hand” process: self-interested
workers and firms accomplish a social goal that no
one had in mind, i.e., allocative efficiency.
4-6
Efficiency Revisited
• The “single wage” property of a competitive
equilibrium has important implications for
economic efficiency.
o Recall that in a competitive equilibrium the wage equals the
value of marginal product of labor. As firms and workers move to
the region that provides the best opportunities, they eliminate
regional wage differentials. Therefore, workers of given skills
have the same value of marginal product of labor in all markets.
• The allocation of workers to firms that equates
the value of marginal product across markets is
also the sorting that leads to an efficient
allocation of labor resources.
4-7
Wages and International
Trade: NAFTA
• NAFTA created a free trade zone in North America.
• Free trade reduces the income differential between the
United States and other countries in the zone, such as
Mexico.
• Total income of the countries in the trade zone is
maximized as a result of equalized economic
opportunities across the countries in the zone.
4-8
Competitive Equilibrium in Two
Labor Markets Linked by Migration
Dollars
Dollars
s
SN
SS
SS
A
wN
B
w*
C
w*
wS
DN
Employment
(a) The Northern Labor Market
DS
Employment
(b) The Southern Labor Market
Suppose the wage in the northern region (wN) exceeds the wage in the
southern region (wS). Southern workers want to move North, shifting the
southern supply curve to the left and the northern supply curve to the
right. In the end, wages are equated across regions at w*.
4-9
Wage Convergence Across
States
5.7
LA
Percent Annual Wage Growth
GA
NH
ME
VT
VA
5.5
MS
AR
5.3
MD
MA
IA
FL
NC
SC
KS
MI
CT
DE
TN
AL
NE
5.1
OK
TXMO
RI
MN
PA
WI
NJ
WV
IN
OH
IL CO
UT
WA
NY
KY
AZ
ND
4.9
SD
MT CA
NM
NV
4.7
ID
OR
WY
4.5
.9
1.1
1.3
1.5
Manufacturing Wage in 1950
1.7
1.9
Source: Olivier Jean Blanchard and Lawrence F. Katz, “Regional Evolutions,”
Brookings Papers on Economic Activity 1 (1992): 1-61.
4-10
Payroll Taxes and Subsidies
• Payroll taxes assessed on employers lead to a
downward, parallel shift in the labor demand curve.
o The new demand curve shows a wedge between the
amount the firm must pay to hire a worker and the
amount that workers actually receive.
o Payroll taxes increase total costs of employment, so
these taxes reduce employment in the economy.
o Firms and workers share the cost of payroll taxes,
since the cost of hiring a worker rises and the wage
received by workers declines.
o Payroll taxes result in deadweight losses.
4-11
The Impact of a Payroll Tax Assessed
on Firms
Dollars
S
w1 + 1
A
w0
w1
B
w0  1
D0
D1
E1
E0
Employment
A payroll tax of $1
assessed on
employers shifts
down the demand
curve (from D0 to
D1). The payroll tax
decreases the wage
that workers receive
from w0 to w1, and
increases the cost of
hiring a worker from
w0 to w1 + 1.
4-12
The Impact of a Payroll Tax Assessed on Workers
Dollars
S1
S0
w0 + 1
w1
w0
w1  1
D0
D1
E1
E0
Employment
A payroll tax assessed
on workers shifts the
supply curve to the left
(from S0 to S1). The
payroll tax has the
same impact on the
equilibrium wage and
employment regardless
of who it is assessed
on.
4-13
The Impact of a Payroll Tax put on
Firms with Inelastic Supply
Dollars
S
D0
w0
A
B
w0 – 1
D0
D1
E0
Employment
A payroll tax assessed
on the firm is shifted
completely to workers
when the labor supply
curve is perfectly
inelastic. The wage is
initially w0. The $1 payroll
tax shifts the demand
curve to D1, and the
wage falls to w0 – 1.
4-14
Payroll Subsidies
• An employment subsidy lowers the cost of hiring for
firms.
• This means payroll subsidies shift the demand curve for
labor to the right (up).
• Total employment will increase as the cost of hiring has
fallen.
4-15
The Impact of an
Employment Subsidy
S
w0 + 1
B
w1
w0
A
w1 – 1
D1
D0
E0
E1
An employment subsidy of
$1 per worker hired shifts up
the labor demand curve,
increasing employment. The
wage that workers receive
rises from w0 to w1. The
wage that firms actually pay
falls from w0 to w1 – 1.
Employment
4-16
The Impact of a Mandated Benefit
S0
Dollars
w* + C
S1
P
S0
Dollars
P
S1
w0
w0
w* + B
Q
w1
R
w*
R
w*
w0  C
D0
D0
D1
E1
E*
E0
D1
Employment
E0
Employment
(a) Cost of mandate exceeds worker’s valuation (b) Cost of mandate equals worker’s
valuation
4-17
Immigration
• As immigrants enter the labor market, the labor supply
curve shifts to the right.
o Total employment increases.
o Equilibrium wage decreases.
4-18
Effect on Native-born
Workers
• Immigration reduces the wages and employment of
similarly-skilled native-born workers, but native-born
workers may be able to increase their productivity by
specializing in tasks better suited to their skills.
• Competing native workers will have lower wages;
complementary native workers will have higher wages.
4-19
The Short-Run Impact of Immigration When
Immigrants and Natives Are Perfect Substitutes
Dollars
Supply
w0
w1
Demand
N1
N0
E1
Employment
As immigrants and natives
are perfect substitutes, the
two groups are competing
in the same labor market.
Immigration shifts out the
labor supply curve. As a
result, the wage falls from
w0 to w1, and total
employment increases
from N0 to E1. At the lower
wage, the number of
natives who work declines
from N0 to N1.
4-20
The Short-Run Impact of Immigration when
Immigrants and Natives are Complements
Dollars
Supply
w1
w0
Demand
N0
N1
Employment
If immigrants and natives
are complements, they do
not compete in the same
labor market. The labor
market here denotes the
supply and demand for
native workers. Immigration
makes natives more
productive, shifting out the
labor demand curve. This
leads to a higher native
wage and to an increase in
native employment.
4-21
The Long-Run Impact of Immigration When
Immigrants and Natives Are Perfect Substitutes
Dollars
Supply
w0
w1
Demand
N0
N0 +
Immigrants
Employment
Immigration initially shifts
out the labor supply curve
so the wage falls from w0
to w1. Over time, capital
expands as firms take
advantage of the cheaper
workforce, shifting out the
labor demand curve and
restoring the original
wage and level of native
employment.
4-22
The Native Labor Market’s Response to Immigration
Dollars
Dollars
S0
S2
S0
S1
PLA
S3
PPT
w0
w0
w*
w*
wLA
Demand
Demand
Employment
Employment
(a) Los Angeles
(b) Pittsburgh
Originally, both markets pay equilibrium wages of w0. After immigration into
Los Angeles, both markets eventually converge to a new equilibrium wage
at w*, which is less than w0.
4-23
The Short-Run Labor Demand Curve Implied by
Different Natural Experiments
Dollar
s
Dollar
s
D
Demand curve
implied by minimum
wage natural
experiment
Demand curve
implied by Mariel
natural experiment
w*
D
Employment
(a) Mariel
E*
Employment
(b) NJ-Pennsylvania
minimum wage
(a) The analysis of data resulting from the Mariel natural experiment implies that increased immigration does
not affect the wage, so that the short-run labor demand curve is perfectly elastic. (b) The analysis of data
resulting from the NJ-Pennsylvania minimum wage natural experiment implies that an increase in the
minimum wage does not affect employment, so that the short-run labor demand curve is perfectly inelastic.
4-24
California’s Population, 1950-1990
(% U.S. Population Living in California)
4-25
Scatter Diagram Relating Wages and
Immigration for Native Skill Groups
4-26
The Immigration Surplus
Dollars
S
S
A
B
w0
C
w1
F
D
0
N
M
Employment
Prior to immigration, there are N
native workers in the economy
and national income is given by
the trapezoid ABN0. Immigration
increases the labor supply to M
workers and national income is
given by the trapezoid ACM0.
Immigrants are paid a total of
FCMN dollars as salary. The
immigration surplus gives the
increase in national income that
accrues to natives and is given
by the area in the triangle BCF.
4-27
The Cobweb Model
• Two assumptions of the cobweb model:
o
o
Time is needed to produce skilled workers.
Persons decide to become skilled workers by looking at conditions in the labor market at the
time they enter school.
• A “cobweb” pattern forms around the equilibrium.
• The cobweb pattern arises when people are misinformed.
• The model assumes naïve workers who do not form rational
expectations.
• Rational expectations are formed if workers correctly perceive the
future and understand the economic forces at work.
4-28
The Cobweb Model in the Market
for New Engineers
Dollars
S
w1
w3
w*
w2
w0
D
D
E0
E2
E*
E1
The initial equilibrium wage in
the engineering market is w0.
The demand for engineers
shifts to D, and the wage will
eventually increase to w*.
Because new engineers are
not produced instantaneously
and because students might
mis-judge future opportunities
in the market, a cobweb is
created as the market adjusts
to the increase in demand.
Employment
4-29
Policy Application: Hurricanes and
the Labor Market
• Hurricanes generate exogenous economic shocks that
affect labor market conditions.
• Can use data to estimate difference-in-difference models
that examine the economic impact on affected Florida
counties relative to unaffected counties.
• Next slide data: 19 hurricanes that hit Florida between
1988 and 2005.
4-30
Changes in Employment and Wages in Florida
Counties Hit by Hurricanes
Percent change in
employment
Percent change in
earnings
1. Effect of category 1-3
hurricane on county
directly hit
-1.5
+1.3
2. Effect of category 4-5
hurricane on county
directly hit
-4.5
+4.4
3. Effect of category 1-3
hurricane on neighboring
county
+0.2
-4.5
4. Effect of Category 4-5
hurricane in neighboring
county
+0.8
-3.3
Source: Ariel R. Belasen and Solomon W. Polachek, “How Disasters Affect Local Labor Markets: The Effects of
Hurricanes in Florida,” Journal of Human Resources, forthcoming 2009, Table 4.
4-31
Policy Application: Hurricanes and
the Labor Market
• How does the theory of labor market
equilibrium gain support from this data?
o Labor supply decreases in counties directly hit, and more so in
the more-affected counties. This increases wages and lowers
employment.
o Labor supply increases in neighboring counties. This decreases
wages and increases employment.
4-32
Noncompetitive Labor
Markets: Monopsony
• Monopsony market exists when a firm is the only buyer
of labor.
• Monopsonists must increase wages to attract more
workers.
• Two types of monopsonist firms:
o Perfectly discriminating
o Nondiscriminating
4-33
Perfectly Discriminating
Monopsonist
• Discriminating monopsonists are able to hire different
workers at different wages.
• To maximize firm surplus (profits), a perfectly
discriminating monopsonist “perfectly discriminates” by
paying each worker his or her reservation wage.
4-34
Nondisriminating
Monopsonist
• Must pay all workers the same wage, regardless of each
worker’s reservation wage.
• Must raise the wage of all workers when attempting to
attract more workers.
• Employs fewer workers than would be employed if the
market were competitive.
4-35
The Hiring Decision of a Perfectly
Discriminating Monopsonist
Dollars
S
A
w*
w30
VMPE
w10
10
30
E*
Employment
A perfectly discriminating
monopsonist faces an upwardsloping labor supply curve and
can hire different workers at
different wages. Therefore the
labor supply curve gives the
marginal cost of hiring. Profit
maximization occurs at point A.
The monopsonist hires the same
number of workers as a
competitive market, but each
worker is paid his or her
reservation wage.
4-36
The Hiring Decision of a
Nondiscriminating Monopsonist
Dollars
MCE
VMPM
S
A
w*
w
M
VMPE
EM
E*
Employment
A nondiscriminating
monopsonist pays the same
wage to all workers. The
marginal cost of hiring exceeds
the wage, and the marginal
cost curve lies above the
supply curve. Profit
maximization occurs at point A;
the monopsonist hires EM
workers and pays them all a
wage of wM.
4-37
The Impact of the Minimum Wage on a
Nondiscriminating Monopsonist
Dollars
MCE
S
A
w*
The minimum wage may
increase both wages and
employment when imposed
on a nondiscriminating
monopsonist. A minimum
wage set at w increases
employment to E.
w
wM
VMPE
EM
E
Employment
4-38
Monopoly in the Product Market:
A Review
• Firms that have monopoly power can influence the price
of the product that they sell.
• Monopolist faces a downward sloped market demand
curve for its output and an even lower downward sloped
marginal revenue curve.
4-39
The Output Decision of a
Monopolist
Dollars
MC
pM
p*
A
MR
q M q*
D
Output
A monopolist faces a downwardsloping demand curve for her
output. The marginal revenue
from selling an additional unit of
output is less than the price of the
product. Profit maximization
occurs at point A where the
monopolist produces qM units of
output and sells each unit of
output at a price of pM dollars.
4-40
The Labor Demand Curve
of a Monopolist
Dollars
w
The marginal revenue product
gives the worker’s contribution
to a monopolist’s revenues (or
the worker’s marginal product
times marginal revenue), and is
less than the worker’s value of
marginal product. Profit
maximization occurs at point A
where the monopolist hires
fewer workers (EM) than would
be hired in a competitive market.
A
MRPE
EM
E*
VMPE
Employment
4-41