Chapter 1

Introduction to Labor EconomicsIntroduction to Labor Economics

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

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Why study Labor Economics?

• Human resources allocate substantial time and energy to labor markets.

• Labor economics studies how labor markets work.

• Labor economics helps us understand and address many social and economic problems facing modern societies.

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Basics of the Labor Market

• Participants are assigned motives:

– Workers look for the best job.

– Firms look for profits.

– Government uses regulation to achieve goals of public policy.

• Minimum wages• Occupational safety

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Three “Actors”• Workers

– The most important actor; without workers, there is no “labor”.

– Desire to maximize (i.e., to optimize by selecting the best option from available choices).

– Supplies more time and effort for higher payoffs, causing an upward sloping labor supply curve.

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Three “Actors”

• Firms

– Decide who to hire and fire.

– Motivated to maximize profits.

– Relationship between price of labor and the number of workers a firm is willing to hire generates the labor demand curve.

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Three “Actors”

• Government

– Imposes taxes, regulations.

– Provides ground rules that guide exchanges made in labor markets.

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Why Do We Need a Theory?

• Explain and understand how labor markets work.

• Focus on the essential variables while leaving out other, less crucial, factors.

• Create a model that helps explain the theory.

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Positive vs. Normative Economics

• Positive economics– Addresses the facts– Focus on “what is”– Questions answered with the tools of economists

• Normative economics– Addresses values– Focus on “what should be”– Requires judgments

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Labor market vs. other markets

• labor services are rented, not sold,

• labor productivity is affected by pay and working conditions, and

• the suppliers of labor care about the way in which the labor is used

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Internal labor market

A firm uses an internal labor market if:

• external hiring is used primarily for entry-level jobs, and

• higher level positions are filled by promotion from within the firm

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Internal labor market

Internal labor markets exist because the use

of such markets:

• reduces hiring and training costs,

• improves employee morale and motivation, and

• reduces the effect of uncertainty

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Primary vs. Secondary labor markets

• primary labor market - high wages and stable employment relationships.

• secondary labor market - low wages and unstable employment relationships

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Labor force and unemployment

• labor force = noninstitutionalized individuals aged 16 or above who are either working or actively seeking work.

• unemployed = those who are not working but are “actively looking for job”

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Unemployment rate

•Discouraged workers are workers who have given up looking for work. • An increase in the number of discouraged workers causes the unemployment rate to fall.

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Labor force participation rate

• the labor force participation rate rises during an expansion and falls during a recession.

• fluctuations in the labor force participation rate over the course of the business cycle dampen cyclical fluctuations in the unemployment rate

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Sectoral shifts in employment

• primary sector (agricultural) employment has declined as a share of the labor force,

• secondary sector (industrial) employment has declined slightly as a share of the labor force, but only in the past few decades, and

• tertiary sector (service sector) employment has increased as a share of the labor force.

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Reasons for the shifts in employment• the primary sector (agriculture) is

characterized by rapid growth in labor productivity and a low income elasticity of demand,

• the secondary sector is characterized by rapid growth in labor productivity and a moderately high income elasticity of demand, and

• the tertiary sector is characterized by slow growth in labor productivity and a high income elasticity of demand

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Nominal and real wages

• Nominal wages are not adjusted for inflation and are said to be expressed in terms of “current dollars.”

• Real wages are wages that have been adjusted to take into account the effect of inflation. Real wages are expressed in terms of dollars from a given base year and are said to be expressed in “constant dollars.”

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Wages, earnings, total compensation and income

• wage = payment per unit of time• earnings = wage x hours• total compensation = earnings + fringe

benefits• fringe benefits = payments-in-kind + deferred

compensation• income = total compensation + unearned

income (or income = earnings + unearned income)

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The Markets in Which Firms Must Operate

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Demand for labor

The labor demand curve is downward sloping due to:• a substitution effect, and• a scale effect.

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Substitution effect

• substitution effect - substitution of other resources for a resource that becomes relatively more expensive.

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Scale effect

The scale effect associated with a wage

increase involves the following steps:• higher wages result in higher average and

marginal costs of production,• leading to an increase in the equilibrium price

of the product,• leading to a reduction in the quantity of the

product demanded,• leading to a reduction in the use of all inputs

used to produce the product.

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Shifts in labor demand

Labor demand may shift due to changes in:

• the demand for the product, and

• the prices of other resources.

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Industry demand for labor

• An industry's demand for labor consists of the total demand for a particular type of worker in a given industry. (An industry consists of all of the firms that produce a given type of output.)

• An industry's labor demand curve is determined by adding together the labor demand curves for all of the firms in the industry.

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Market demand for labor

• The market for a given category of labor consists of all of the firms that might hire a given type of labor, regardless of the industry in which the firm operates.

• The market demand for labor is determined by adding together all of the industry demand for labor curves.

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Market labor supply

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Shifts in market labor supply curve

Shifts such as this may be due to:

• changing wages in other markets, or

•changes in worker tastes and preferences

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Collective bargaining agreement

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Supply restriction

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Overpaid and underpaid workers

• economists argue that workers are overpaid if their wage is above the equilibrium,

• workers are underpaid if their wage is below the equilibrium wage

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Supply and Demand in the Engineering Market

Equilibrium

50,000

40,000

30,000

20,00010,000 30,000

Labor Supply Curve

Labor DemandCurve

Earnings ($)

Employment

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Summary

• Labor economics studies how labor markets work.

• Models in labor economics typically contain three actors: workers, firms, and governments.

• A good theory should have realistic assumptions and can be tested with real-world data.

• The tools of economics are helpful in answering positive questions.

End of Chapter 1