©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 12: Labor Markets, Poverty, and Income Distribution

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 12: Labor Markets, Poverty, and

Income Distribution


2

Learning Objectives

1. Understand the relationship between wages and the marginal productivity of workers

2. Analyze how wages and employment are determined in competitive labor markets

3. Compare and contrast the various hypotheses economists have proposed to explain earnings differences

4. Discuss recent trends in income inequality and philosophical justifications for income redistribution

5. Describe and analyze some of the methods used to reduce poverty


3

Story

Winning a gold medal at the Olympics can bring fame and fortune to many athletes Nawal Al Moutawakil, a Moroccan gold

medalist in the 400-meter hurdles at the Los Angeles Summer Olympic Games in 1984

Since her 1984 win, she gained her fortune from: Product endorsements / TV appearances / Earning several international awards / Serving as a member of the International Olympic Committee / Her appointment as the Minister of Youth and Sports in Morocco


4

Story

However, a silver or bronze medalist, despite potentially being within a hairbreadth to winning can drop completely from view The silver medalist from 1984 has dropped

completely from view Judi Brown, an American athlete, and

although potentially just as talented as Al Moutawakil, wealth and international recognition were not to be hers

Individual income vary widely Comparable skills seem to earn different

incomes


5

Story

Many physicians in Arab countries such as Egypt are likewise every bit as talented and hardworking as physicians in the West However, American physicians earn an

average annual income of almost $200,000 Egyptian physicians earn as little as $63 a

month that most of them (about 89%) supplement their incomes by holding multiple jobs

Why do some people earn so much more than others? No other single question in economics has

stimulated nearly as much interest and discussion


6

The Economic Value of Work

In some respects, the sale of human labor is profoundly different from the sale of other goods and services

For example, although someone may legally relinquish all future rights to the use of her television set by selling it, the law does not permit people to sell themselves into slavery

The law does, however, permit employers to “rent” our services

In many ways the rental market for labor services functions much like the market for most other goods and services


7

The Market for Labor

Economics analysis applies to labor markets Equilibrium wage and quantity are

determined by supply of and demand for a each category of labor

Labor categories include unskilled, skilled, managers, and so on

Changes in supply and demand will change the equilibrium wage and quantity


8

Khazaf Works

Pottery uses free clay and labor Selling price is $1.10 per piece

Handling costs are $0.10 per piece Net price is $1.00 per piece

Rafiq and Lina each work full time at potting Rafiq delivers 100 pots per week and Lina

delivers 120• If the labor market for potters is perfectly competitive,

how much will each be paid?- Assume that the values of the pots that Rafiq and

Lina deliver are $100 and $120 respectively


9

Khazaf Pottery Works

Rafiq earns $100 and Lina earns $120 per week

One reason for different

earnings is differences in

output per person If Khazaf paid Rafiq only $90 per week, the

company would then enjoy an economic profit of $10 per week as a result of hiring him

Seeing this cash on the table, a rival firm could then offer Rafiq $91, thus earning an additional economic profit of $9 per week by bidding him away from Khazaf

Khazaf will have difficulty keeping Rafiq if it pays him less than $100 per week

That will be his competitive equilibrium wage


10

The Labor Market


11

The Labor Market

General rule in a competitive labor market is: A worker’s pay in long-run equilibrium will be

equal to his or her VMP—the net contribution he or she makes to the employer’s revenue

wage = VMP

Employers would be delighted to pay workers less than their respective VMPs But if labor markets are truly competitive,

they cannot get away with doing so for long


12

Potters' Production

To summarize: Value of Marginal Product

Marginal product of labor multiplied times the net price of each unit sold ($1)

• Rafiq’s VMP is $100 and Lina’s VMP is $120 In a competitive market each worker is paid

the value of his marginal product

Each worker’s VMP is independent of the number of other workers employed by the firm In such cases, we cannot predict how

many workers a firm will hire


13

Ouzai Woodworking Company

Makes cutting boards from free scrap wood Price of a cutting board is $20

Going wage is $350 per week# of Workers

Output

0 0

1 30

2 55

3 76

4 94

5 108

VMP

$600

500

420

360

280

MP

30

25

21

18

14


14

Ouzai Woodworking Company

The company will hire workers until the value of the marginal product of the last worker is equal to the wage Cost-Benefit Principle Workers earn $350 per week

Hire four workers The fifth worker costs

more ($350) than the benefits he delivers ($280)

# of Workers

VMP

1 $600

2 500

3 420

4 360

5 280


15

Firm’s Decision to Hire

Note the similarity between the perfectly competitive firm’s decision about how many workers to hire and the perfectly competitive firm’s output decision When labor is the only variable factor of

production, the two decisions are essentially the same

There are three important factors: The number of boards cut The price of cutting boards The wage rate

An increase in product price will lead employers to hire more workers

Employers also will increase hiring when the wage rate falls


16

The Equilibrium Wage and Employment Levels

The equilibrium price and quantity in any competitive market occur at the intersection of the relevant supply and demand curves

The same is true in competitive markets for labor Demand curve for labor employer Supply curve for labor employee


17

Demand for Labor employer

An employer’s reservation price for a worker is the most the employer could pay without suffering a decline in profit The reservation price for the employer in a

perfectly competitive labor market is simply the value of the worker’s marginal product (VMP)

Because of the law of diminishing returns, the VMP declines in the short run as the quantity of labor rises DL = VMP


18

Wag

e ($

/hou

r)W

age

($/h

our)

Firm 1

Firm 2

Work hours/day

Total Employment

Wag

e ($

/hou

r)

Market

Demand for Labor

100

12

50

12

150

6

6

100

D1 = VMP1

D2 = VMP2

D = VMP1 + VMP2

150

12

250

6


19

Supply for Labor employee

Individuals trade-off income and leisure More work hours means more income AND

less leisureSuppose the wage increases

Substitution effect: work more Leisure is more expensive

Income effect: work less Purchasing power increases for a given work

schedule A higher wage may increase or decrease the

quantity of labor supplied by the individual

Work Hours


20

Labor Supply of Programmers

Labor supply for a single profession has a positive slope Higher wages attract

workers from other careers

An increase in wages from W1 to W2 increases quantity of labor supplied from L1 to L2 Movement along the

labor supply curve

Employment of programmers(work-hours/year)

Wag

e ($

/hou

r)

S

L1

W1

L2

W2


21

Market Shift: Increase in the Demand for Programmers

Demand for programmers increases from D1 to D2

Initial impact is a shortage of programmers at W1

In the short-run, wages are bid up to W3

In the long run Movement up the supply

curve and down the demand curve

Quantity of labor supplied increases from L1 to L2

Wages settle at W2

Employment of programmers(work-hours/year)

Wag

e ($

/hou

r)

S

L1

W1

D1

D2

L2

W2

W3


22

Market Shift: Increase in the Demand for Programmers

Labor markets are often relatively slow to adjust

When the demand for workers in a given profession increases, shortages may remain for months or even years It all depends on how long it takes people

to acquire the skills and training needed to enter the profession (or to change profession to the one in demand)


23

Explaining Differences in Earnings

When labor markets are competitive, differences in wages are determined by differences in VMP Lina earned 20% more than Rafiq because

she made 20% more pots each week than he did

This difference in productivity may have resulted from an underlying difference in talent or training, or perhaps Lina simply worked harder than Rafiq

Yet often we see large salary differences even among people who appear equally talented and hardworking


24

Explaining Differences in Earnings

Why, for instance, do lawyers earn so much more than those plumbers who are just as smart as they are and work just as hard? And why do surgeons earn so much more than general practitioners?

No-Cash-on-the-Table Principle says that only differences in talent, luck, or hard work can account for long-run differences in earnings If plumbers could earn more by becoming

lawyers, why don’t they just switch occupations? Answer to that is Human Capital Theory


25

Human Capital and Differences in Earnings

Human capital theory holds that an individual’s VMP (or wage) is proportional to his or her stock of human capital Human capital stock is a mixture of factors

such as

Individuals make decisions about acquiring human capital

Factors Affecting Differences in Earnings

Education Experience Training

Intelligence Energy Work Habits

Trustworthiness Initiative Political Skills


26

Human Capital and Differences in Earnings

Some jobs require more human capital

For example, a general practitioner could become a surgeon, but only by extending her formal education by several more years

An even larger investment in additional education is required for a plumber to become a lawyer

These jobs usually pay more Demand for specific kinds of human

capital also cause earnings differences


27

Labor Unions and Differences in Earnings

In general, two workers with the same amount of human capital may earn different wages if one of them belongs to a labor union and the other does not

A labor union is a group of workers who bargain collectively with employers for better wages and working conditions entry to the union is restricted

Unions restrict the supply of labor and raise wages Similar to a cartel Unions increase the supply of labor to the non-union

companies Wages in non-union companies go down


28

Market Equilibrium Without Unions

Wag

e ($

/hou

r)

D1 = VMP1

125

9

Market 1

Employment

Wag

e ($

/hou

r)

D2 = VMP2

75

9

Market 2

Total employment(workers/day)

Wag

e ($

/hou

r)

S0

200

D = VMP1 + VMP2

9

Total Market


29

Market 1 Is Unionized

Workers in market 1 unionize

Negotiate a wage of $12 25 workers out of work In market 2, labor

increases by 25 workers from market 1

Wage decreases to $6 Employment increases to

100 Net welfare loss to society Move workers from low

VMP to high VMP will increase total surplus

Wag

e ($

/hou

r)

125

9

D1 = VMP1

Market 1

Employment

Wag

e ($

/hou

r)

75

9

D2 = VMP2

Market 2

12

100

6

100


30

Size of the Union Wage Advantage

Our analysis of two markets resulted in union workers earning twice the non-union wage Suggest unionized firms have a cost

disadvantage

Unionized firms remain competitive Unions attract most productive workers

Union workers are more skilled and experienced Wage gap is ±10% for comparable human capital

Unions increase productivity Improved communications and motivation Lower labor turnover means lower costs


31

Compensating Wage Differentials

If people are paid the value of what they produce, why do chefs earn more than lifeguards? Preparing food is important, to be sure, but is it

more valuable than saving the life of a drowning child?

Similarly, why plumbers may get paid more than teachers? Is replacing faucet washers really more valuable

than educating children? The wage for a particular job depends not

only on the value of what workers produce, but also on how attractive they find its working conditions


32

Compensating Wage Differentials

Compensating wage differentials describe the difference in wage rates from differences in working conditions Wages depend on VMP and also on working

conditions Workers have preferences about their work

schedule, environment and other conditions Working in less desirable conditions increases

wage

Safety and work schedule are conditions that matter to workers


33

Discrimination in the Labor Market

Wage differentials not based on differences in VMP leave cash on the table On average, women and minorities

receive lower wages than white males Pattern holds even if we compare people with

similar human capital levels

One way to explain differential is that some human capital differences are not measured

Another view attributes the differential to discrimination


34

Employer Discrimination

Employer discrimination is an arbitrary preference by an employer for one group of workers over another

Assumptions Productivity is distributed the same

for men and women Average productivity is the same

One employer prefers to hire male employees


35

Employer Discrimination

Discriminating firm has higher costs than non-discriminator Discriminating employers earn lower

profitsNon-discriminator has higher profits

Expands business Eventually supply of women is exhausted

Bid up female wagesNo Cash on the Table Principle results

in equal wages between discriminator and non-discriminator


36

Discrimination by Others

If employer discrimination is not the primary explanation of the wage gap, what is?

Customer discrimination causes buyers to pay more for goods produced by favored group for the same product Attorneys: Some groups more credible with

juries and clients than others Reduces incentives for non-favored groups to enter the

profession Socialization within the family can affect

individual's career choices and therefore the supply of labor Traditional female roles: nurses, teachers,

secretaries


37

Other Sources of the Wage Gap

Basis for compensating wage differentials Willingness to accept risk

Coal mining, entrepreneurs, construction, farming

Quality versus quantity of education Difficult to measure

Courses taken and degrees (humanities versus sciences) pursued by sex and race

Wage gaps remain across industries and occupations

If one group disproportionately pursues higher-paid occupations, wage gap will persist


38

Winner-Take-All Markets

Winner-take-all markets are ones in which small differences in human capital translate into large differences in pay Technology plays a role Some participants earn high salaries

Many more do notExamples

Entertainment Law Consulting

Medicine Investment Banking CEOs

Publishing Design, Fashion Academia


39

Trends in Inequality

An attractive feature of the free-market system is that it rewards initiative, effort, and risk taking The harder, longer, and more effectively a

person works, the more he or she will be paidYet relying on the marketplace to

distribute income also entails an important drawback: Those who do well often end up with vastly

more money than they can spend Those who fail often cannot afford even basic

goods and services.


40

Trends in Inequality

Market outcomes produce disparities in income

Median Income by Quintile for US (2005 dollars)

Quintile 1980

Bottom 20%

$14,386

Second 20%

31,316

Middle 20%

47,308

Fourth 20%

65,634

Top 20% 110,507

Top 5% 157,094

2000

$16,008

36,602

57,525

84,781

177,879

315,205

1990

$14,241

33,217

51,157

73,569

136,725

214,527


41

US Median Income by Quintile

$100,000

$200,000

$300,000

$350,000

Bottom 20%

Second 20%

Middle 20%

Fourth 20%

Top 20% Top 5%

1980 1990 2000

Growing inequality


42

Recent Trends in Inequality

From WWII to the 1970s income growth was ± 3% per year for all groups

Between 1980 and 2000, growth rates increase from bottom quintile to top

Does not show mobility between groups Median income is not a measure

of individual welfare In 1980, CEOs earned 42 times

salary of average worker By 2000, this multiple increased

to more than 500 times

Median Income

Growth1980 - 2000

Bottom 20%

11%

Second 20%

17%

Middle 20%

22%

Fourth 20%

29%

Top 20% 61%

Top 5% 101%


43

Is Income Inequality a Moral Problem?

The "right" income distribution is a normative matter

Rawls proposed a "fair" income distribution is one that people would accept before they know their position in the distribution Equality of distribution is favored by the

strongly risk averse Since an unequal income distribution would

involve not only a chance of doing well but a chance of doing poorly, most people would prefer to eliminate the risk by choosing an equal distribution


44

Acceptable Income Distributions

If income is distributed equally, total output is smaller than in a country with earnings incentives

Rawls argued that inequality would be acceptable if it increases total output by "enough"

Rawls also argued that the market system produces more inequality than acceptable Fear of being disadvantaged beats hope of

being rich Fairness requires some attempt to reduce

income inequality produced by the market


45

The Challenge of Income Redistribution

Raising incomes of the needy reduce incentives to work Difficulty distinguishing between

needy and others Risk takers may appear "needy" People who prefer not to work are

ineligible Hurricane victims

No perfect solution Choose among imperfect alternatives


46

Welfare Payments and In-kind Transfers

In-kind transfers are direct transfers of goods or services Food subsidies, subsidized public

housing, subsidized school meals, free education, and health care


47

Welfare Programs in Egypt

One of the most important welfare programs in Egypt comes in the form of food subsidies, which cover sugar, cooking oil, tea, and rice The green card targets low-income households and

provides a higher rate of subsidy The red card targets higher-income households and

provides a lower rate of subsidy Critics of this program charge that ambiguous

selection criterion and weak monitoring have rendered the subsidies ineffective

Green cards: held by 61 percent of households in the three richest quintiles, which receive 62 percent of total benefits.

Red cards: held by 10 percent of households in the poorest two quintiles (in lieu of green cards).


48

Means-Tested Benefit Programs

A means-tested program means that the more income a family has, the smaller are the benefits it receives under these programs Intends to avoid paying benefits to those who

can support themselvesAdministrative structure discourages work

If benefits are reduced by $1 for each $2 earned, participants in multiple programs may lose more benefits than the income they earn

Administrative costs are high Simplify the program and distribute the cost

savings to the needy


49

The Negative Income Tax (NIT)

Negative income tax is a tax credit for each person financed by tax on earned income

With no taxes, pre-tax income equals after-tax income

With NIT, low income families receive a cash transfer while high income families pay tax

Family with no income would receive the federal poverty threshold

Aft

er-T

ax I

ncom

e($

000s

)Pre-Tax Income

($000s)

No Taxes

10 15 20

10

15

20

NIT

14

16tax

transfer


50

Negative Income Tax

Advantages Incentive to work is greater than with

welfare Lower administrative cost

Disadvantages Creates and incentive not to work The political cost is high

NIT guarantees income to all who do not work Would need to be at least as large as the

government’s official poverty threshold, if sole means of insulating people against poverty


51

Negative Income Tax and Poverty


52

Negative Income Tax and Poverty

According to the World Bank, the poverty threshold is $1.25 per day, which represents about $450 per year.

In the U.S. it is $21,756 for a family of four. Couldn’t eight families in the U.S. live

nicely with $144,000 per year (from pooling their negative tax payments) after moving to a home in the mountains?

Two practical difficulties: More people living at the government’s

expense would make the program prohibitively costly

The program is likely to be quickly abandoned by political supporters


53

Minimum Wage Legislation

Minimum wage above equilibrium creates unemployment Loss in total surplus L1 workers earn more (L0 – L1) are unemployed Change in total earning

depends on the elasticity of demand for labor

Studies show little effect of minimum wage on employment Loss in total surplus may be small

W

L0L1

Wmin

Unemployment

Employment

Wag

e ($

/hou

r) S

D


54

Employer surplus$12.5K

L (work-hours/day)

W (

$/ho

ur)

S

D

10

5,000

5

0

Worker

surplus

$12.5K

No Minimum Wage

Minimum Wages and Total Surplus

L (work-hours/day)

S

W (

$/ho

ur)

D

5,000

5

10

0

Total surplus lost

($4K)

Employer surplus($4.5K)

Minimum Wage ($7)

3

3,000

7

Worker surplus

($16.5K)


55

Public Employment for the Poor

Government could employ the poor If wages are the same as the private sector,

some workers will prefer government jobs Increases the cost of the program

Make-work programs are not productive Increases size of government

Acting alone, government-sponsored jobs for the poor or the negative income tax cannot solve the income-transfer problem But a combination of these programs might

do so


56

A Combination of Methods

Use a NIT with payment set below the poverty threshold

Set the public service wage below the minimum wage

Privatize the management of the public service employment program

NIT

Public Job

NIT + Public Job

NIT + Private Job

Povertythreshold

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©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 12: Labor Markets, Poverty, and Income Distribution