Questions: (1) Where do the labor
demand and supply curves come from?
(2) How well do they explain the facts?
12_01
WAGE
(PRICE OF
LABOR)
Labor
supply
Market
wage
Labor
demand
QUANTITY OF LABOR
Amount of labor where
quantity of labor supplied
equals quantity of labor
demanded
The Slowdown in Wage Growth
12_02
INDEX,
1992 = 100
110
Real wage
100
90
Low growth
trend
80
High growth
trend
70
60
1960
1965
1970
1975
1980
1985
1990
1995
2000
Two sides of the labor market:
Firms and Workers
• Labor Demand
– The firm’s decision
• Labor Supply
– The worker’s decision
Derived Demand for Labor
• Labor demand is a derived from firm’s
profit maximization decisions
• Firm chooses output to maximize profits
(MC = P)
• This amount of output implies a level of
labor input (short run)
– a production function all over again
Market power? Not yet, let’s first
start with competition
• A firm in a competitive market for its good:
takes price as given
• But now also assume that the labor market
is competitive: firm takes wage as given
Example: Competitive Firm with
P = $100 (T12.1)
Workers Quantity Marginal Total
Marginal
produced Product Revenue Revenue
Product
0
1
2
3
4
5
0
17
31
42
51
58
-17
14
11
9
7
0
1700
3100
4200
5100
5800
-1700
1400
1100
900
700
To derive the labor demand
curve, first plot MRP by hand
Marginal Revenue Product
Equals Wage
• Condition for Profit Maximization
• In symbols: MRP = W
• For firms in competitive markets:
– MRP = PxMP
– example 1700 = 100x17 or 1400 = 100x14
• This implies that MP = W/P
– Marginal product of labor equals real wage
To get market demand for labor,
sum up firms’ demands for labor
12_04
WEEKLY WAGE
(DOLLARS)
WEEKLY WAGE
(DOLLARS)
1,500
1,000
1,500

1,500
1,000
500
0
WEEKLY WAGE
(DOLLARS)

500
5
10
QUANTITY OF LABOR
(NUMBER OF WORKERS)
LABOR DEMAND AT GETAJOB
0
1,000
500
5
10
0
QUANTITY OF LABOR
(NUMBER OF WORKERS)
LABOR DEMAND AT CAREERPRO
5
10
15
20
QUANTITY OF LABOR
(NUMBER OF WORKERS)
LABOR DEMAND IN THE MARKET
What if firm has market power
as in a monopoly?
• Still must have MRP = W
• But in this case MRP does not equal P=MP
– because P is not fixed
– P must decrease as L and Q go up
Derivation of Labor Supply
• analogy with earlier analysis of consumer
behavior: purposeful choices (work versus
“leisure”) with limited resources (only 24
hrs in a day)
• The “price of leisure” is the opportunity
cost of not working = wage
• As the wage rises, the price of leisure rises
– thus the person will work more
“Leisure” includes school!
• Investing in human capital
• more human capital increase marginal
product of a worker
Substitution versus income
effect in labor supply
• Recall the two effects for a good
– the two effects go in the same direction
• in case of labor supply the two effects go in
opposite directions
– hence labor supply can slope down!!!!!!!
3 different labor supply curves
12_05
WAGE
WAGE
Labor
supply
QUANTITY OF LABOR
SUBSTITUTION EFFECT DOMINATES
WAGE
Labor
supply
QUANTITY OF LABOR
SUBSTITUTION EFFECT EQUALS
INCOME EFFECT
Labor
supply
QUANTITY OF LABOR
INCOME EFFECT DOMINATES
Backward bending labor supply
curve
12_06
WAGE
Income effect
dominates in
this region.
Income and
substitution effects
balance out.
Substitution effect
dominates in this
region.
LABOR SUPPLY
A Test: compare trend in labor
productivity with trend in real
wage
12_07
INDEX,
1992 = 100
110
Labor productivity
100
90
Low growth
trend
80
70
High growth
trend
60
50
1960
1965
1970
1975
1980
1985
1990
1995
2000
But productivity theory does not
explain everything
• Compensating wage differentials
– salaries in the business school versus the
economics department
• “Efficiency” Wages
• Long Term Employment Contracts
– wage is related to productivity over long
periods, but not short periods
Effects of Minimum Wage
12_09
WAGE
WAGE
Quantity of
labor demanded
Quantity of
labor supplied
Labor market
equilibrium
Labor
supply
Labor
supply
Surplus
Minimum
wage
Labor
demand
Labor
demand
QUANTITY OF LABOR
Market for Unskilled Workers
QUANTITY OF LABOR
Market for Skilled Workers
Discrimination in competitive
markets
12_08
WAGE
1. Prejudiced firm acts
as if marginal revenue
product is lower than
it actually is.
Labor supply
4. Because actual marginal
revenue product is higher
than the wage, other firms
can hire these women at a
higher wage but still below
the marginal revenue
product.
2. Discrimination
causes wages
to fall by this
amount.
Actual marginal
revenue product
NUMBER OF WOMEN WORKERS
3. Discrimination also
causes lower
employment for women.
Effects of Labor Unions