Prof. Bryan Caplan

Econ 103

Spring, 2000


Week 8: Labor Markets and Labor Regulation

I.                     Labor Demand and Marginal Productivity

A.                 Labor demand just shows the quantity of labor-hours people want to buy at a given real wage.  It is just the sum of all employers' labor demand curves.

B.                 Question: What determines an employer's willingness to pay for another hour of labor? 

C.                Define a worker's marginal productivity as the additional quantity of a good that he produces per hour times the market value of that good.

1.                  Ex: If a worker produces 4 extra gallons of ice cream per hour of work, and ice cream sells for $4.00/gallon, his marginal productivity is $16.00/hour. 

D.                If the market wage of a worker is less than his marginal productivity, he will be hired.  An employer will keep buying more labor until it is no longer profitable.  It follows that the market wage must equal a worker's marginal productivity

1.                  If workers' marginal productivity is $16.00/hour, the last employee hired will produce exactly $16 worth of additional output, and receive his marginal productivity.

E.                 Amazing conclusion: Labor Demand is entirely determined by workers' marginal productivity.  The more a worker can produce, and the greater the value of the product he products, the more employers are willing to pay to employ him.

II.                   Labor Supply, Choice of Occupation, and the Labor/Leisure Trade-off

A.                 People have to make two kinds of decisions about their time:

1.                  Their occupation.

2.                  How many hours to work, that is, how much of their labor to sell on the market.  The rest economists call "leisure."

B.                 (While employers rarely let people "pick their own hours," people can choose their occupations and employers to try to match their desired labor/leisure mix).

C.                For any one individual, it is unclear whether labor supply curves have much, if any, elasticity.

D.                But people definitely choose occupations based partly on wages, which means that the labor supply curve for any one occupation will be fairly elastic.

E.                 Thus, as usual, the labor supply curve shows the total number of hours that will be sold at a given wage.

III.                  Equilibrium in the Labor Market

A.                 Many people balk at the application of S and D analysis to labor, but their objections are rather weak.  As usual, just look at the intersection of S and D to figure out the wage (the "price of labor") and the employment level (the "quantity of labor").

B.                 If the wage is below the intersection of S and D, employers want to hire more workers than are willing to work.  They accordingly bid up the wage.

C.                If the wage is above the intersection of S and D, more workers are willing to work than employers want.  People often call this "unemployment."  Workers bid down the real wage.

D.                At the intersection of S and D, the quantity of labor hours employers desire to buy and the quantity of labor hours employees desire to sell are equal.

IV.               Shifts in Labor Demand and Labor Supply

A.                 What shifts labor D?  The two components of marginal productivity: physical productiveness and the value of the product produced.

B.                 Thus, if workers' get stronger, making them able to produce more stuff, and the price of the product sold stays the same, labor demand shifts up.  This increases both wages and employment.

C.                Similarly, if the value of the workers' product rises, labor demand shifts up, increasing both wages and employment.

D.                This is a powerful analytical lens.  For example, suppose that workers randomly vandalize company property.  What happens to wages?

E.                 What shifts labor S?  This is more complicated.

1.                  Difficulty of acquiring the ability to do the job.

2.                  Unpleasantness of the task.  (Special term: When workers get paid extra for doing unpleasant work, this is called a "compensating differential").

3.                  Other occupational options.

F.                 Important point: Recall that all markets are interconnected.  This means that wages can rise even in occupations where productivity is stagnant.

1.                  The barber example

G.                How can this be used to explain:

1.                  Market for grape workers?

2.                  Market for lawyers?

V.                 Involuntary Unemployment as a Product of Regulation

A.                 At the equilibrium wage, there are neither labor shortages nor surpluses; unemployment is voluntary (not in the sense that it is cause for celebration, but in the sense that people do not want to work more at the market wage).

1.                  Analogy: Voluntary datelessness.

B.                 Note: "Full employment" has NOT been "assumed."  The assumption is that the wage is flexible; the conclusion of full employment follows.

C.                How could involuntary unemployment be possible in this model?  Only if regulation keeps the real wage too high!

D.                There are three regions on the graph.

1.                  At wages above the equilibrium, there is a surplus of labor and wages are "too high."

2.                  At wages below the equilibrium, there is a shortage of labor and wages are "too low."

3.                  At the equilibrium wage, the labor market clears.

E.                 Note: There is no region where workers are underpaid AND underemployed!

VI.               How Labor Market Regulation Works

A.                 Suppose for example that the equilibrium wage is $10/hr.  If the government imposes a minimum wage of $15/hr., there will be unemployment.  Employers will want to hire fewer people than want to be hired at the market wage.

B.                 Similarly, if the government mandates new benefits (safety, health, family leave, etc.) and forbids real wages to fall, involuntary unemployment will be the result.

1.                  What happens if the government mandates benefits but allows the real wage to change?

C.                Suppose a union were able to impose a $15/hr. minimum wage?  Would the consequences be the same?

D.                What about plant-closing laws?  Regulations against lay-offs or firing?  Employment lawsuits?

E.                 In the U.S., the minimum wage plays a small role - less than 5% of the workforce earns the minimum wage.  Mandated benefits, mandatory overtime, and other regulations play a bigger role.

F.                 Interesting case: in the U.S. during the Great Depression, real wages for the employed actually rose!  (More on this later).

G.                In other countries, especially in Europe, labor market regulations are typically very strict.  Their enormous and persistent unemployment rates of 10, 15, or 20%, compared to less than 5% than the U.S, are an important warning of the dangers of "labor market rigidities."

VII.              Why the Standard Story of Labor is Wrong

A.                 Most history books tell a story something like this:

1.                  In the days before the minimum wage, unions, etc., life was terrible for workers because employers paid them whatever they felt like paying them.

2.                  But then government became more progressive, and changed the laws.

3.                  Life is now better for workers because employers' greed has been tamed.

B.                 This makes no sense at all.  Why?

C.                Employers compete with other employers; they care about their own profits, not the profits of employers in general.  Workers have always earned their marginal productivity.

D.                Why then were workers paid less in the past?  Their marginal productivity was lower!  As technology progressed, the marginal productivity of workers increased, and labor demand accordingly went up.

E.                 Suppose government had imposed strict regulations when productivity was low?  The result would have been higher wages for the lucky, but permanent unemployment (and probably starvation) for the rest.

F.                 The problem of workers in the Third World isn't lack of regulation, but low productivity.  Of course, low productivity can be a product of a crummy political system, but you can't solve that problem with labor market regulation.

VIII.            Competitive Labor Markets and Discrimination

A.                 Economists have also analyzed the economics of discrimination and anti-discrimination law.  Again, there is a large gap between the analytically-informed interpretation and the emotional story people like to believe.

B.                 First consider discrimination by employers.  If it means anything, it means that they are willing to pay higher wages to members of liked groups and lower wages to members of disliked groups assuming their marginal productivity is the same.

C.                The last point is crucial.  You can't compare average wages of different groups, and assume the lower-paid group is the victim of discrimination.  You have to control for differences in training and ability.

D.                Now suppose that employers dislike the Irish even though they are just as efficient as non-Irish.  Irish wages are according lower.  But can this situation endure?

E.                 Under these conditions, the less prejudiced an employer is, the higher his profits.  Greed provides a strong incentive to judge people based on their marginal productivity.

F.                 In the long-run, the least prejudiced employers come to dominate the market because they are consistently more profitable.

G.                Second, consider discrimination by fellow employees.  In this case, the simplest solution for a greedy employer is segregation.  If the non-Irish dislike the Irish (and would only work with them for a compensating differential), why not just separate the two groups?

H.                 Last, consider discrimination by consumers.  This is probably the most credible kind of discrimination.  But again, the easiest way around it is to just slightly mask the involvement of the disliked group.

I.                     If this is right, then what do anti-discrimination laws do?  They reduce "protected" groups' expected marginal productivity!  It's a standard incidence problem.  If I know you could sue me if I hire you, my demand for your services falls.

J.                  If discrimination laws make group-varying wages legally dangerous, then anti-discrimination laws function like price controls: Employees who can sue get the same wage as employees who can't, so why hire the former?

K.                 Also interesting: Almost all cases are brought against firms that did hire members of protected groups.  Discrimination suits at the hiring stage are very rare.  So less discriminatory employers may be more likely to get sued than more discriminatory employers.