GBS 610-LABOUR ECONOMICS

Simple model of the labour

markets

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Lecture Outline
Quick recap: The Labor Market: Definitions,
Facts, and Trends
How the Labor Market Works
• The Demand for Labor
• The Supply of Labor
• The Determination of the Wage

Applications of the Theory

• Who Is Underpaid and Who Is Overpaid?
• Unemployment and Responses to Technological
Change Across Countries
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.1 The Labor Market: Definitions, Facts, and Trends

➢ The market that allocates workers to jobs and

coordinates employment decision is the labor
market, which could be:

• Regional

• Local

• external

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.1 The Labor Market: Definitions, Facts, and Trends

The Labor Force and Unemployment

➢ The Adult Working Population (AWP) consists of those who
are over 16 years of age (in Zambia) and are in the labor
force (LF) and not in labor force (NLF).
AWP = LF + NLF
➢ The labor force consists of those who are employed (E) and
those who are unemployed (U) but are actively seeking
work or waiting to be recalled from layoff.
LF = E + U
➢ People who are not employed and are neither looking for
work or waiting to be recalled from layoff are classified as
not in labor force (NLF).
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.1 The Labor Market: Definitions, Facts, and Trends

The Earnings of Labor

Nominal and Real Wages

• The wage rate is the price of labor per working hour, which
could measured in nominal and/or real terms:
▪ Nominal wage – what workers get paid per hour in
current terms.
▪ Real wages or the real purchasing power of a worker’s
earnings

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.1 The Labor Market: Definitions, Facts, and Trends
Wages, Earnings, Compensation, and Income
• Wages refer to the payment for a unit of time/hour worked.
• Earnings refer to wages multiplied by the number of time
units/hours worked.
• Employee Benefits can be either payments in kind or deferred
▪ Examples of payments in kind are employer-provided health care,
health insurance, and paid vacation time.

• Total compensation consists of earnings plus employee

benefits.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
➢ Firms must successfully operate in the labor market, the
capital market, and the product market if they are to survive
➢ Firms purchase inputs – labor (L) and capital (K) used in
the production of goods and services – from the labor
market and the capital market, respectively
➢ The study of the labor market begins and ends with an
analysis of the demand for and the supply of labor
• Employers/Firms demand for labor from different labor markets
• Employees/Workers supply their labor services
➢ Main features of the labor market outcomes are related to:
(a) the terms of employment (wages, compensation levels,
working conditions) and
(b) the levels of employment.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.5 The Markets in Which Firms Must Operate

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
The Demand for Labor
➢ Firms combine L and K to produce goods and services that
are sold in the product market.
➢ Firms’ total output (Q) and their mix of inputs (L and K)
depend on three forces:
• Output or product demand (QD).
• The amount of L and K acquired at given prices: wages
(W) for L and rental cost (rK) or price (pK) for K.
• Choice of technology (T ) available to firms.
Demand for labor: LD = f (W, QD, T )
where LD = labor demand or the desired level of
employment by the firm, W = wage rate, QD = output or
product demand, and T = technology.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
➢ If QD and T are held constant, then LD = g(W ),

Wage Changes
• An increase in wage will lead to:

▪ A scale or output effect – the reduction in the scale of

production or output due to the reduction in employment.

▪ A substitution effect – capital is substituted for labor in the

production process.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.6 Labor Demand Curve

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Changes in Other Forces Affecting Demand
• If the demand for the product (QD) increases, holding other
factors (L, W, K, rK or pK, and T ) constant, this will lead to
scale or output effect as firms try to maximize profits; thus
leading to an increase in labor demand.

▪ The labor demand curve shifts to the right at every possible

wage level indicated in Table 2.3 – see Figure 2.7.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.7 Shift in Demand for Labor Due to Increase in Product Demand

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Changes in Other Forces Affecting Demand
• If the supply of capital changed and rK or pK fell by 50%, but
other factors remained unchanged, more K would be used in
production process – generates two opposite effects for LD:

▪ If the scale effect dominates, more workers will be required as

well, thus LD will shift to the right – see Figure 2.8 (a).

▪ If the substitution effect dominates as firm adopt more capital-

intensive technologies in response to cheaper capital, LD will shift
to the left – see Figure 2.8 (b).

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.8 Possible Shifts in Demand for Labor Due to Fall in Capital Prices

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Market/Industry and Firm Demand
• The demand for labor can be analyzed on the following
levels:
▪ Firm level – to analyze the demand for labor by a particular firm, we
see how an increase in the wage rate of machinists affects their level
of employment.
▪ Market – to see how the wage increase affects the entire labor
market for a particular occupation in all industries in which they are
used, we use a market demand curve.

Long Run versus Short run

• In the short run, employers find it difficult to substitute capital for
labor (and vice versa); and this is also true for product demand.
• It takes time to fully adjust consumption and production behavior.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
The Supply of Labor
➢ The simplifying assumption here is that workers have
already decided to work, but they must choose their:
• Occupation
• Employer

Market Supply
• If the market wage for legal assistants (or “paralegals”)
increases and the salaries and wages in other occupations are
held constant, more workers would want to become paralegals:
▪ Labor supply of paralegals will be upward-sloping – see Figure 2.9
▪ The quantity of labor supply will be positively related to the wage
rate, holding other wages constant.
• Other factors such as an increase in the wage rate of insurance
agents, but the wage rate (W ) of paralegals is unchanged, the LS
curve of paralegals will shift to the left – see Figure 2.10.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.9 Market Supply Curve for Paralegals

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.10 Shift in Market Supply Curve for Paralegals as Salaries of Insurance
Agents Rise
Supply of Paralegals when
Salaries of Insurance Agents Are:
Wages for
Paralegals

High

Low

Number of Paralegals
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Supply to Firms
• We assume that the labor market for paralegals is perfectly
competitive, and that no firm will offer a wage that is above or
below what the market wage indicates – firms are wage takers:
▪ Labor supply curves of paralegals to a firm are horizontal
– see Figure 2.11.
▪ At the on-going wage of W0, employers can hire all the paralegals
they need and each employer faces S0 supply curve.

• Note that a fall in the wage rate of paralegal does not mean
withdrawals from the paralegal profession into the insurance agent
market because they are not perfect substitutes.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.11 Supply of Paralegals to a Firm at Alternative Market Wages

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
The Determination of the Wage
➢ The wage rate that prevails in the labor market depends on LD
and LS, regardless of whether labor unions and/or nonmarket
factors are involved – see Figure 2.12.
The Market-Clearing Wage
• The wage rate (We) at which LD equals LS is the market-clearing
wage – that is, no labor surplus and/or no labor shortage.
• For any wage (W1) lower than We: LD > LS → EDL, and with
adjustments from employers/demanders, wage rises to We.
• For any wage (W2) higher than We: LD < LS → ESL, and with
adjustments from workers/suppliers, wage falls to We.
• We becomes the going wage that individual employers and
employees face – see Figures 2.12 and 2.13.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.12 Market Demand and Supply

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.13 Demand and Supply at the “Market” and “Firm” Levels

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Disturbing the Equilibrium
• Changes in labor demand or changes in labor supply or the
simultaneous changes in labor demand and supply will
change the equilibrium wage (We) and employment (L):
▪ If LD shifts to the right, We rises to We* – see Figure 2.14.
▪ If LS shifts to the left, We rises to We’ – see Figure 2.15.
• If the LS curve shifts to the right – see Figure 2.16 – or the LD
curve shifts to the left, market wage will fall from We to We”.
• If LS shifts to the left and this is accompanied by a rightward
shift in LD, market wage will rise dramatically with net
employment increase.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.14 New Labor Market Equilibrium after Demand Shifts Right

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.15 New Labor Market Equilibrium after Supply Shifts Left

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Figure 2.16 New Labor Market Equilibrium after Supply Shifts Right

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.2 How the Labor Market Works
Constraints to adjustment
• The labor market is subject to forces that impede the
adjustment of both wages and employment to changes in
supply or demand:
▪ Changing jobs often requires an employee to invest in new
skills or bear the costs of moving.
▪ Hiring workers can involve an initial investment in search and
training, while firing them or cutting their wages can be
perceived as unfair, which may affect moral and productivity.
• Other barriers to adjustment are rooted in nonmarket forces:
▪ Government programs or laws such as minimum wage laws
usually serve to keep wages above market levels, which could
result in widespread unemployment.
▪ Customs or institutions (labor unions) also constrain the
choices of individuals and firms.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.3 Applications of the Theory
Who Is Underpaid/Overpaid?
➢ The concepts of underpayment and overpayment have to do
with the social issue of producing goods and services in the
least-costly way, hence the comparison of overpayment and
underpayment with market-clearing wage.
Above-Market Wages
• Workers whose wages are higher than the market-clearing
wage are considered to be overpaid – two implications:
▪ Employers are paying more than necessary to produce their
output: (WH > We).
▪ More workers want jobs than they can find: Y > V → ESL
– see Figure 2.17.
• Wage reduction close to the level dictated by the market
would be Pareto-improving.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.17 Effects of an Above-Market Wage

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
2.3 Applications of the Theory

Below-Market Wages
• Employees whose wages are below market-clearing levels
are considered to be underpaid:
▪ At below-market wages, employers face labor shortages due
to WL < We – see Figure 2.18.
▪ If workers are made to work at WL wage, it will be difficult for
employers to find and keep workers, and those who remain
will be dissatisfied and resentful; therefore, production of
goods and services will be affected – see Example 2.2.
▪ If wages were to increase close the market-clearing level
(We), more workers will be attracted to the market and output
would rise as employment would increase from V to X.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 Figure 2.18 Effects of a Below-Equilibrium Wage

Modern Labor Economics: Theory and Public Policy, Twelfth Edition, Global Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.