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Yale ECON 115 - The Labor Market

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The Labor Market1. Labor demand2. Labor supply3. Labor market equilibrium ignoring unemployment4. Unemployment5. Europe and the U.S.6. Discrimination1Labor DemandAssumptions• Hold capital stock fixed (for now)• Workers are all alike. We are going to ignore differences in worker’saptitudes, skills, ambition and so on.• Labor market is competitive. Firms view the wage of the workers theyhire as being determined in a competitive market labor market and notset by the firms themselves. (No monopsony power.)• Firms are perfectly competitive in the product market (No monopolypower.)• Firms maximize profits.2• A firm’s profit is the difference between its revenue and its costs:π(Q)=R(Q) − C(Q)whereπ(Q) = profitsR(Q) = total revenueC(Q) = total economic cost• A firm in perfectly competitive environment revenue is price times out-put: R(Q)=P × Q.• Recall that we have worked with a production function:Q = F (K, L)whereQ = outputK = productive services of capitalL = laborF is a function.3• Note that outputs and inputs are measure per units of period of time.That is– Output is in number of units production per month, quarter, or year.– Labor is measured in hours per week, month or year or in workersper week, month or year• Marginal product of labor (MPL)MPL =change in outputchange in labor input=ΔqΔLThe marginal product of labor measure the productivity of the lastincremental increase in labor.4• Recall we write the total cost asC = w × L + r × K• So we rewrite the firm’s profits as:π(L)=P × F (K, L) − (w × L + r × K)• So the firm wants find the choose the level of output to maximize profits.It chooses this level of output by choosing how much labor to hire.• Plot P × F (K, L) and (w × L + r × K) as functions of L.• Profits are maximized where the slope of the profit function is zeroΔπ(L)ΔL= PΔQΔL−ΔC(Q)ΔL=0= PΔF (K, L)ΔL− w =0= P × MPL − w =0• So profits are maximized when P × MPL = w.5• Analysis at the margin. A firm compares the costs and benefits of hiringone extra worker.– If the real wage(w) is greater than the marginal product of labor(MPL), the firm is paying the marginal worker more than theworker produces, so a profit-maximizing firm will reduce the numberworkers to increase profits.– If w<MPL, the marginal worker produces more than he or she isbeing paid, so a profit maximizing firm will increase the number ofworkers.• The labor demand schedule specifies how many units of labor (suchas man-hours) firms would hypothetically like to hire at any givenprevailing wage.• The labor demand curve is the MPL curve.• Labor demand schedule slopes downward: firms want fewer workersand a shorter workweek when the real wage is high.6Comparative Statics• Labor demand shifts out when– P increases– MPL increases• Labor demand shifts out when– P decreases– MPL decreases7Labor Supply - The Income-Leisure Tradeoff• Utility depends on consumption, C and leisure, l:Utility = U (C, l)• Need to compare the costs and benefits of working an additional day.– Cost: loss of leisure time– benefit: more consumption, since income is higher• Let’s be a little more specific.• Resources of an individual and prices the individual faces:Ls= time spent work (i.e labor supplied)h = total hours in a dayw = real wageΦ = real non-labor wealth or profits8• Time constraintl + Ls= h• So the budget constraint of this individual isC = wNs+ΦC = w(h − l)+Φ• We can graph a person’s preferences for consumption leisure using in-difference curves.• The optimal choice occurs where the marginal rate of substitution - thetradeoff between consumption and leisure – equals the real wage. Thevalue of the extra consumption to the person from working a little morejust has to be equal to value of the lost leisure that it takes to generatethe consumption. The real wage is the amount of consumption thatthis person can purchase if she gives up an hour of leisure.9Comparative StaticsAn increase in Φ• So suppose you win the lottery. What would happen to your supply oflabor? What would happen to your demand for leisure?• For most people, they would probably demand more leisure. In otherwords, leisure is a normal good for most people.10An increase in the wage rate, w• When the wage rate rises the leisure become more expensive, which byitself leads people to want less of it (the substitution effect).• If leisure is a normal good, we would then predict that an increase inthe wage rate would lead to a decrease in the demand for leisure – andthus an increase in the supply of labor.• A normal good must a negative sloped demand curve. If leisure is anormal good, then the supply curve of labor must be positively sloped.• But wait – there is a problem with the analysis. At an intuitive level,it may not seem reasonable that an increase in the wage rate wouldalways lead to an increase in the supply of labor. If my wage becomesvery high I might spend some of extra income consuming leisure.• Get a backward bending supply curve for labor.11• There are two effects – an income effect and a substitution effect.• The income effect is the tendency of workers to supply less labor inresponse to become wealthier.• The substitution effect is the tendency of workers to supply more laborin response to a higher real wage.• An increase in the real wage shifts the budget constraint. The kinkin the constraint remains fixed, and the budget constraint becomessteeper. Consumption will increase, but leisure may rise or fall, becauseof the opposing substitution and income effects.• The substitution effect captures the movement along the indifferencecurve in response to the increase in the real wage. The real wage hasincreased so the relative cost of leisure has risen relative to consumption.• The income effect holds the real wage constant.• Note an increase in non-labor income, Φ has a pure income effect, withno substitution effect.• Which effect will dominate?• In general, as countries become wealthier, its citizen supply less labor.But in the short run the substitution effect dominates. As we said, thisimplies an upward sloping supply curve for labor.12The aggregate labor supply curve• The aggregate labor supply curve is the sum of the labor supplied byeveryone in the economy.• The aggregate labor supply schedule specifies how many units of laborhouseholds


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