Prof. Bryan Caplan

bcaplan@gmu.edu

http://www.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

Week 3: Labor and Unemployment

  1. Real Wages and the Labor/Leisure Trade-off
    1. People have to make decisions about how much to work, that is, how much of their labor to sell on the market. The rest, of course, they keep for themselves. Economists term the first "labor," and the second "leisure," though of course your labor might be fun and your leisure might be unpleasant.
    2. You might decide...
      1. ...not to work at all. Several different terms can apply: "student," "homemaker," "retired," etc.
      2. To work "part-time," significantly less than 40 hours/week.
      3. To work "full-time," about 40 hours/week.
      4. To work a lot more.
      5. In U.S. government statistics, you are either "employed," "unemployed and looking for work," or "out of the labor force."
    3. Since you have 168 hours in a week, when you pick your hours of labor L, you simultaneously pick your hours of leisure (168-L).
    4. 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.
    5. What determines the quantity of labor that people want to supply? The simplest answer is: the REAL WAGE, the quantity of goods you get for an hour of work. Just mechanically apply the law of supply to labor, and discover that the higher the "price" of labor, the more labor people want to sell. This is known as the substitution effect.
    6. But there is a major complication: Normally, sellers of a good consume at most a tiny amount of their own product. Orange growers, for example, spend less than 1% of their income on oranges. However, sellers of labor consume an ENORMOUS amount of their own product; even the most extreme workaholic consumes 50% of his own hours in leisure.
    7. Why is this important? An increase in the price of what you sell makes you richer, enabling you to afford more of everything. If you already consume a lot of what you sell, then as the price of your product rises, your tendency to buy more of everything (including your own product) as you get richer may overpower your tendency to sell more of your product as its price rises. This is known as the income effect.
    8. Somewhat shocking implication: For products that are a large percentage of their budget - such as their own time - suppliers might actually sell LESS as the price rises, not more as economists usually assume. Their supply curve might be "backwards-bending."
    9. Implausible? Suppose your real wage was $10 an hour. How many hours a week would you work? What about $5? $1? $.10? It seems like almost everyone's labor supply curve will "bend backward" at some point.
    10. Empirically, males in the past did sell far more hours of their time than they do today. It definitely looks like the income effect was greater than the substitution effect in their case: as real wages increased, men have worked less.
    11. Women sold far fewer than they do today, but this is a clear case where fun and "leisure" are different! Big effect for women: development of machines to do household tasks leaves them with surplus time, which more and more have chosen to sell.
    12. The substitution effect is by no means always weaker than the income effect. In the modern U.S., people in highly-paid professions often work the most hours, even when they are self-employed !
    13. Complication: Substitution effect still matters enormously for choice of which job to take and when to take it.
      1. Ex: Jobs in computers.
      2. Ex: Temporary jobs.
  2. Aggregate Labor Supply
    1. If you add up everyone's labor supply curves, and abstract from differences between workers, you can draw the Aggregate Labor Supply curve. This curve shows the total number of hours people will choose to work at given wages.
    2. Depending on the relative strength of the substitution and income effects, this curve could be positively or negatively sloped.
    3. For most purposes, it is however fairly reasonable to just assume that the Aggregate Labor Supply is more or less vertical.
      1. Typical hours of work have stopped falling for the past couple decades.
      2. Intuitively, how many adult males want less than a 40-hour/week job?
    4. Throughout this course, then, the Aggregate Labor Supply curve will normally be drawn as vertical.
    5. But notice that this is an empirical assumption; for Aggregate Supply, in contrast, the vertical shape is a theoretical conclusion.
  3. Aggregate Labor Demand and Marginal Productivity
    1. Aggregate Labor Supply is determined by people's trade-offs between labor and leisure. What then determines Aggregate Labor Demand?
    2. Recall that Aggregate 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.
    3. Question: What determines an employer's willingness to pay for another hour of labor?
    4. Define P to be the price level, W to be the nominal wage for an hour of work, and y to be the amount of output a worker produces in an hour.
      1. The real wage is therefore W/P.
      2. Further define the marginal productivity of an hour of work to be the nominal value a worker produces: P*y.
    5. An employer will keep buying more labor until it is no longer profitable. It is profitable to hire a worker so long as: P*y³ (W/P)*P. If the nominal value a worker produces in an hour is greater than or equal to the nominal hourly, he is profitable to employ.
      1. Ex: If P=$1 and y=3, a worker produces $3/hour. Employers want to hire him if the market wage is $3 or less.
    6. Equivalently, it is profitable to hire a worker so long as: y³ W/P. If a worker's real hourly output is greater than or equal to his real wage, he is profitable to employ.
    7. Imagine employers adding more and more workers to their workforce until it ceases to be profitable. They finally stop hiring more once the last worker's marginal productivity is exactly equal to his wage.
    8. Amazing conclusion: Aggregate Labor Demand is entirely determined by workers' marginal productivity.
  4. Equilibrium in the Labor Market
    1. Aggregate Labor Supply is determined by workers' labor/leisure trade-offs. Aggregate Labor Demand is determined by workers' productivity. So what determines real wages and employment?
    2. If the real wage is below the intersection of ALS and ALD, employers want to hire more workers than are willing to work. They accordingly bid up the real wage.
    3. If the real wage is above the intersection of ALS and ALD, more workers are willing to work than employers want. Workers bid down the real wage.
    4. At the intersection of ALS and ALD, the quantity of labor hours employers desire to buy and the quantity of labor hours employees desire to sell are equal.
    5. What happens if...
      1. Workers get stronger?
      2. Someone invents a new productive technique?
      3. Someone invents the dishwasher?
      4. A new law bans the use of some machinery?
      5. Workers get lazier?
    6. Marginal productivity also determines how many workers work in each sector of the economy. For example, when agricultural productivity increases (one farmer can grow more crops), the price of farm products usually falls by more than the quantity grown increases. (There are only so many loaves of bread you can eat). People spend more on non-agricultural products instead. So people leave agriculture and go into industry. [Simon graph]
  5. Involuntary Unemployment as a Product of Regulation
    1. 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.
    2. Note: "Full employment" has NOT been "assumed." The assumption is that the real wage is flexible; the conclusion of full employment follows.
    3. How could involuntary unemployment be possible in this model? Only if regulation keeps the real wage too high!
    4. 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.
    5. 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?
    6. Suppose a union were able to impose a $15/hr. minimum wage? Would the consequences be the same?
    7. What about plant-closing laws? Regulations against lay-offs or firing? Employment lawsuits?
    8. 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.
    9. Interesting case: in the U.S. during the Great Depression, real wages for the employed actually rose! (More on this later).
    10. 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."
  6. Voluntary Unemployment as a Process of Search
    1. Big oversimplification of the supply-and-demand model - assumes all employers and workers are the same. In reality, people have to search for good "matches," where the skills of the worker fit the requirements of the job.
    2. Such search takes time: interviewing, comparing options, reading the want ads, and even re-locating.
    3. Such search can be a frustrating experience for both workers and employers: workers don't have a job, face rejection, etc.; employers spend work hours going over applications, interviewing candidates, don't get their first choice, etc.
    4. What positive function then does job search serve? The better the "fit" between jobs and talents, the greater productivity is. (Imagine randomly assigning people to different jobs!)
    5. How much should a worker search? You trade-off between the lost wages of searching, and the potentially higher wage you will earn if you find a good match. Employers make the same trade-off.
    6. Insofar as unemployed workers are engaged in useful search activities for unknown opportunities, it makes sense to view them as voluntarily unemployed.
    7. It is a much bigger puzzle if workers' best match is obvious, but unemployment persists. With flexible wages, this wouldn't happen - unemployed workers would bid wages down.
  7. The Natural Rate of Unemployment
    1. Unemployment will always exist because people have to spend time searching for suitable jobs. Regulation of labor markets tends to create additional unemployment.
    2. At any given time, some people are finding jobs, others are leaving them.
    3. What determines the typical level, or "natural rate," of unemployment, where the people getting jobs and losing jobs approximately balance out?
    4. Demographics play a key role. Younger people are less certain about what they want to do, and are changing more rapidly. Women are much more likely to quit or start work for family-related reasons. According, more young people and more women typically lead to a higher natural rate of unemployment.
      1. This is not a bad thing; remember that search serves a vital economic function.
    5. Similarly, more highly educated workers change jobs much less. Being more specialized, they have probably already found a good match. Less educated workers change jobs more; their best use is less certain, and changes more.
    6. Regulation can greatly increase the natural rate. Consider net job creation in the U.S. versus the E.C. from 1970-96: 47 M for the U.S. (+58%), versus 18 M for the E.C. (+12%).
      1. Fun facts on gross versus net job creation.
  8. Fallacies
    1. Fallacy #1: Make-work. Many variants: "Reduce the work-week to create more jobs," "NAFTA costs us jobs," "New machines destroyed jobs," "Immigrants are taking our jobs."
    2. The essence of the fallacy: Focusing on effort instead of result. Bastiat calls this "Sisyphism," after the legendary Sisyphus. If people figure out a way to accomplish the same result with less labor, this means that there is more labor to accomplish some other goal.
      1. Partly, this is just a special case of the broken window fallacy, of measuring wealth by inputs rather than output. Saving one person's job may make that person better off, but it also means wasting valuable labor.
      2. Additional confusion: a decline in labor demand only leads to involuntary unemployment if real wages cannot fall.
      3. Unemployment is frequently just a symptom of shifts in labor demand, not a lower level. Unemployment and job search go together, and job search is vital for prosperity.
    3. Fallacy #2: Subsistence wages. Many variants: "Employers pay whatever they want," "The workers are exploited," "Without unions and regulation, workers would still live in poverty."
    4. The essence of the fallacy: Employers have to compete for workers; employers care about their own profits, not the profits of employers in general. If the real wage is too low, then each employer can get richer by raising wages a little bit and attracting more workers.
      1. Lenin: "The capitalists will sell you the rope you are going to use to hang them."
    5. Why then were wages once low in the West, and still low in the Third World? Two words: marginal productivity. When workers' productivity is low, employers won't pay a lot to hire them.
      1. Immigration restrictions are also a big part of the explanation for why wages can be so much lower in some countries than in Western countries. Otherwise, many would move to get higher wages.
    6. What does regulation to raise real wages accomplish? Real wages can go up, but employment goes down. This can mean permanent unemployment (or more likely, still worse jobs in the black market) for those who can't get a job at the regulated level. The same holds for unions.
    7. How can real wages rise for everyone? Worker productivity has to increase. Efforts to "create jobs" by restricting machinery, or union activity such as slow-downs are directly counter-productive.
  9. Applications: Labor Income Taxation; Welfare and the Negative Income Tax
    1. Marginal tax rates and the labor/leisure trade-off.
    2. Basics of the U.S. tax code.
    3. From the point of view of workers, labor income taxation is equivalent to a decline in Aggregate Labor Demand. If Aggregate Labor Supply is vertical, though, labor income taxation has NO effect on total hours worked!
    4. Does this mean that income taxation has no effect on workers' behavior at all? No, but you need to look for more subtle channels:
      1. Channel #1: Shifting from high-paying jobs to fun jobs. Adult males may be unlikely to quit their jobs, but especially if high tax rates persist, they may decide to go into fun careers that produce relatively little for others instead of less fun careers that produce more for others.
      2. Channel #2: Female labor supply. Married women in particular pay a lot of attention to their after-tax earnings when they decide whether to stay in or re-enter the labor force.
      3. Channel #3: Retirement age. People nearing retirement age may be more likely to stop working as tax burdens rise.
      4. Others?
    5. Progressive tax systems, where the marginal tax rate increases, are particularly likely to bring out these responses. They let people earn enough to be comfortable, but then tax them at ever higher rates on their last hour of work.
    6. Analytically, welfare programs are surprisingly similar to income taxes. Two aspects:
      1. Give people, say, $500/month if they have $0 income.
      2. REDUCE their welfare payment 1:1 if they earn anything greater than $0.
    7. The initial payment makes it feasible to live without working. The greater its size, the fewer people work.
    8. The 1:1 reduction feature leaves no incentive to work more than zero. So if you go on welfare, you don't work at all.
    9. Bottom line: standard welfare programs first increase people's wealth, then raise their marginal tax rates to 100%. Both discourage work.
    10. Some have argued for simply abolishing welfare. A more moderate proposal has been the "negative income tax." The essential idea is to reduce the marginal tax rate on welfare recipients below 100% to leave them with an incentive to work. Example:

Traditional Welfare

Negative Income Tax

Earnings

Transfer

Marginal Tax Rate

Earnings

Transfer

Marginal Tax Rate

$0

$8000

100%

$0

$6000

50%

$2000

$6000

100%

$2000

$5000

50%

$4000

$4000

100%

$4000

$4000

50%

$6000

$2000

100%

$6000

$3000

50%

$8000

$0

100%

$8000

$2000

50%

$10,000

$0

15%

$10,000

$1000

50%