Economics 371
Labor Economics
discrimination
monopsony
unemployment
minimum wages
occupational licensing
labor unions
income taxes
diminishing returns
education
welfare programs
job search
Course Essentials
• Course Web Page
– www.marietta.edu/~delemeeg/econ371
• Grades
– Exams (60%)
– Homework (20%)
– Policy/Market Brief (20%)
Economic Way of Thinking




Rationality
Marginal analysis
Scarcity
Positive vs. normative analysis
Economic Models
Objectives  Constraints  Behavior
Labor Market Model
S
wages
w*
D
L*
Labor
Labor Supply: Labor-Leisure Model

Time Allocation Decision:
 Leisure
 Work
Market work
 Household production

 Human
Capital Investment
Formal education
 On-the-job training

Total weekly hours = 168 = H + L
Objective: Utility maximization
maximize U = U( Y, L )
Preference Rankings:
B » A
B » D
D » C
B » C
Possible that A ≡ D
Income
A
C
B
D
I
Leisure
Results of Survey
Average
Actual
1. What is the current federal hourly minimum wage rate?
$6.96
$7.25
2. What is the average hourly wage rate in the US?
$11.30
$18. 46
3. If your employer offers you a 10% increase in your
hourly wage, how would your hours change?
4. Should the minimum wage rate be raised to $10 per
hour?
4%
Yes: 9%
No: 91%
5. Should labor unions be subject to the Sherman Act?
Yes: 52%
No: 48%
6. Should the US adopt a single-payer health system?
Yes: 22%
No: 78%
7. If a 10% payroll tax is imposed on employers, what will
happen to employee wages?
c or d: 65%
Indifference Curves
Income

Locus of all bundles of (Y, L)
that give the same utility
Higher utility to the NE
 Negative slope
 Convex: diminishing MRS
 Can’t intersect

I2
I3
I1
Leisure
Y
MRS 
L
≡ measures willingness to sacrifice
income for leisure
Indifference Curves
Income
Income
ΔL
ΔL
ΔY
ΔY
I2
I1
Leisure
Leisure
MRS1 > MRS2

Which indifference curve represents a
workaholic?
Budget Constraint
Define:
168 = L + H
Y = wH + N
or
Y = w(168-L) + N
Where: w = wage rate
L = leisure
H = hours of work
N = non-labor income
Y = total income
Income
$1680
Example:
w = $10
N=0
Slope = - w
ΔY
ΔL
168
Leisure
Consumer Optimum
Maximize U(Y,L) s.t. Y = wH + N
Income
At point E: MRS = w
E
Y*
Slope of indifference
curve
I1
Leisure
L*
168
Slope of budget
constraint
Corner Solutions
Income
I1
I4
At point A: MRS > w
 Choose more leisure
A
Leisure
168
Reservation Wage: lowest wage at
which one chooses to work
Fred Glick
Income
112
105
100
I1
166
167
168
Leisure
Impact of a Change in Non-Labor Income
What happens to labor supply if you win the lottery?


Assume leisure is
a normal good
Assume:
w = $10
N = $200
Income
As N ↑  H ↓
I2
$400
H
0
Y
128
168
I1
Leisure
Labor Supply and the Lottery
Source: Kimball, Miles S. and Matthew D. Shapiro. “Labor Supply: Are the Income and Substitution Effects Both Large
or Both Small?” Working Paper, May 16, 2003. Accessed online at www-personal.umich.edu/~mkimball/pdf/labor16may2003.pdf.
Impact of a Change in Wages
What happens to labor supply if your wages rise?

Two possibilities:
 As w ↑  H ↑
 As w ↑  H ↓
Income
I2
H <
0
>
w
I1
128
168
I2
Leisure
Wage Change Decomposition

Change in wage has two opposing effects on
labor supply:


Substitution effect
Income effect
“incentive effect”
“lottery effect”
H h h


w w Y
Total
Effect
(?)
=
Substitution
Income
+
Effect
Effect
(+)
(-)
Wage Change Decomposition
Example: Wage increase when SE > IE
Income
Observed Change
TE: H1 to H3
IE: H1 to H2
SE: H2 to H3
I2
Trick: create hypothetical budget line
that is parallel to original budget line
but tangent to new indifference curve
I1
H3 H1 H2
168
Leisure
Backward Bending Labor Supply Curve
wage

Supply
Elasticity of Supply:
% H
E
% w
IE > SE
w*
SE > IE
H*
Males: E ≈ - 0.10 to - 0.20
Females: E ≈ +1.0
Why the gender difference?
Labor (hours)
Premium Pay vs. Straight Pay

FLSA (1938): “time-and-a-half”
for hours beyond 40 per week
Income
Problem Set 1: #10
w =$10: worker chooses
E1 and works H = 40
w =$15: worker relocates
to E2 and works more
than 40 hours
E2
E1
I1
128
Suppose initial hours of work was H = 20.
Would premium pay encourage more work
effort?
I2
168 Leisure
Income Tax



Flat tax
Progressive tax
Lump sum tax
Income
No tax: slope = -w
Flat tax: slope = -(1-t)w
w1 = $10
t = 20%
w2 = (1- 0.2)10 = $8
168 Leisure
What happens to labor supply under the flat tax compared to no tax?
Income Maintenance Programs

TANF







Block grant
Must work after 2 yrs
5 yr limit
SSI
Medicaid
Food Stamps
EITC

3 Basic Features



Basic Benefit: B
Benefit-Reduction Rate: t
Break-even level of income: Yb
S = B - tY
Example:
B = $3000
t = 0.50
Y = $5000
Varies from $164
to $923 a month
S = 3000 – (0.50)(5000) = $500
What is break-even level of income?
Income Maintenance Programs

Policy Objectives
__________________
 __________________
 __________________

Income
S = B - tY

Policy Proposals:

I2
Raise B:



Yb
_________ labor supply
________ program costs
Lower t:


_________ labor supply
________ program costs
I1
H1
168
Leisure
Welfare Case Loads
6
Families (millions)
5
4
3
2
1
0
1970
1974
1978
1982
1986
1990


What caused the drop in caseloads?


1994
1998
2002
1990s economic boom
Expansion of EITC
Welfare reform
Expansion of child care and
training programs
2006
Labor Force Participation Rates
July 2009 (millions)
Population
235.9
Civilian Labor Force
154.5
Employment
140.0
Unemployment
Not in LF
14.5
81.4
LFPR = LF / Pop
u = U / LF
154.5
LFPR 
 65.5%
235.9
14.5
u
 9.4%
154.5
Male and Female LF Participation Rates: 1950-2008
100
90
Male
Percent
80
70
All
60
50
Female
40
30
20
10
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Source: http://www.bls.gov/cps/tables.htm
Male LFPR by Age
100
90
80
70
Percent
60
50
40
30
20
10
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
20-24
25-54
55-64
65 and over
Female LFPR by Age
100
90
80
Percent
70
60
50
40
30
20
10
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
20-24
25-54
55-64
65 and over
Male LFPR by Race
82
80
78
Percent
76
74
72
70
68
66
1970
1975
1980
1985
White
1990
1995
African-American
2000
2005
Male LFPR by Race
100
90
80
70
Percent
60
50
40
30
20
10
0
1970
1975
1980
1985
White
1990
1995
African-American
2000
2005
Female LFPR by Race
70
Percent
60
50
40
30
1970
1975
1980
1985
White
1990
1995
African-American
2000
2005
Secular Trends in LFPR

Falling male LFPR





_____________________________
_____________________________
_____________________________
_____________________________
Rising female LFPR






_____________________________
_____________________________
_____________________________
_____________________________
_____________________________
_____________________________
Cyclical Trends in LFPR


Added worker effect
Discouraged worker effect
LFPR
LFPR is _____________
GDP
time
Human Capital

Formal Education
 ___________?
 ___________?
In 1970, 36% of the labor force was a high
school dropout. In 2002, it was 13%.
 ___________?

On-the-job Training
Age-Earnings Profiles for Males, 2005
$140,000
17 + years
Annual Earnings
$120,000
$100,000
16 years
$80,000
$60,000
12 years
$40,000
< 12 years
$20,000
$0
18-24
25-34
35-44
45-54
55-64
65+
Age
Based on Figure 4.1 in McConnell, Brue, and Macpherson (2006)
Human Capital Investment

Initial cost to be recouped over time
$
College
_________________
HS
________________
______________
18
age
HK Decision Rules

Net Present Value: Go to college if __________
E3
En
E1
E2
NPV  E0 


  
2
3
(1  i ) (1  i ) (1  i)
(1  i) n
Where:
Ei = incremental earnings in year i
i = interest rate
n = expected working life
• Suppose Melinda is considering taking a webmaster training
program that involves direct costs of $3,000 and forgone earnings
$5,000. The training program will increase Melinda’s earnings by
$3,000, $4,000, and $5,000 for the 3 years she plans on working.
• Because she can borrow the funds at an interest rate of 10%, we
will discount the future expected income at an 10% rate.
• What is the present value (PV) of this training program?
• The PV of the training program is positive, Melinda should take
the training program.
PV of $8,000 Investment in Webmaster Training Program
(Interest Rate = 10 Percent)
Year
(1)
0
1
2
3
Incremental
Earnings
(2)
-$ 8,000
$ 3,000
$ 4,000
$ 5,000
Discounted Value
(10 Percent Rate)
(3)
1.000
0.909
0.826
0.751
Present Value
of Earnings
(4)
$
$
$
$
-8,000
2,727
3,305
3,755
$ 1,787
HK Decision Rules

Net Present Value: Go to college if NPV > 0
E3
En
E1
E2
NPV  E0 


  
2
3
(1  i ) (1  i ) (1  i)
(1  i) n
Where:
Ei = incremental earnings in year i
i = interest rate
n = expected working life

Internal Rate of Return: Go to college if _______
Example: r = 12%
i = 8%
Human Capital Model

Implications:
 Time
 Costs
horizon
 Earnings
differential
 Discount rate

Empirical Evidence


Rate-of-return studies: r ≈ _______________
College wage premiums
Cross Country Rates of Return 2003
(in Percent)
0
5
10
15
Finland
16.7
United States
14.3
Norway
12.1
Belgium
10.7
10
Switzerland
Sweden
Denmark
20
8.9
8.3
Based on Example 4.2 in McConnell, Brue, and Macpherson (2006)
College Wage Premiums
2.00
1.90
1.80
1.70
Ratio
1.60
1.50
Female
1.40
1.30
Male
1.20
1.10
1.00
1971
1976
1981
1986
1991
1996
2001
2006
Based on Figure 4.3 in McConnell, Brue, and Macpherson (2006)
Social Rate of Return to HK

External benefits






______________________
______________________
______________________
______________________
______________________
Biases:


______________________
______________________
Neglecting ability _________
gains due to education
Neglecting fringes/psychic benefits
may _________ gains due to education
George Psacharaopoulos and Harry Patrinos, “Returns to Investment in Education: A Further Update,” World Bank
Policy Research Working Paper 2881, September 2002.
Distribution of Earnings: HK explanation
Share of Weekly Earnings of all
Wage and Salary Workers, 2003
Lowest Quintile
5.2%
Second Quintile
10.7%
Third Quintile
15.8%
Fourth Quintile
23.0%
Highest Quintile
45.3%
Source: Mayer, Gerald. “The Distribution of Earnings of Wage and
Salary Workers in the United States, 1994-2003.” December 2004.
Available at http://digitalcommons.ilr.cornell.edu/key_workplace/194
Distribution of Earnings: HK explanation
Demand: diminishing returns to education
Supply: perfectly elastic
r(%)
r1

Differences in HK investment




__________________
__________________
__________________
Capital market imperfections
__________________
 __________________

r2
DB
DA
e1
e2
education
Screening Hypothesis

College degree as sorting device



Low-cost _________ device
College ________ add to HK
 Suggests that social rate
of return is __________
Evidence



“___________ effect”: rate of return on 12th and 16th year
of schooling are much higher than 11th and 15th years
_____________ vs. salaried workers: SE have slightly less
E than salaried
Wise (1975): GPAs and earnings of Ford workers are
____________ correlated
On-the-Job Training

General training
 Raises

productivity to _______ employers
Specific training
 Raises
productivity to ________ employer
Who pays for OTJ?
On-the-Job Training
$
MRPu = productivity without training
MRPp
MRPt = productivity during training
wp
MRPp = productivity after training
wu
MRPU
MRPt
t1
General Training:
wp = MRPp
wt = MRPt
Employee pays thru low training wage
time
Specific Training:
MRPu < wp < MRPp
wt = MRPu
Employer pays for training; employee
is exploited after training
Source: http://www.advicenow.org.uk/go/feature/feature_357.html?pkgid=35
Empirical Models


Earnings = f(education, experience, gender, race, other)
Ln w = β0 + β1S + β2EXP + β3EXP2 + β4X + ε
random error