Modeling Labor Demand and Wages

Theory of Labor Markets

Clearly, poverty and the labor market are inherently connected. Therefore, to understand poverty and poverty policy we must have a model for understanding how the labor market works.

Like most studies of markets in economics, we want to start with the simplest model possible and see where that gets us.

Labor Demand

Consider a production process in the “short-run” (i.e. when firms cannot adjust capital stock) and/or where there are very few substitutes for labor.

What is the benefit of employing another worker hour?

What assumption do we usually make regarding how this benefit changes as more and more worker hours are employed?

Labor Demand

Graphically?

Worker Hours Output MP Output Price VMP1 11 11 22 21 10 23 30 9 24 38 8 25 45 7 26 51 6 25 56 5 27 60 4 28 63 3 29 65 2 2

Labor Demand

Main assumptions:1. Firms are profit maximizers

2. Workers are interchangeable

3. Labor markets are “competitive”

What do these assumptions mean in words? Do they seem reasonable?

Labor Demand

What is the cost of hiring another worker hour?

So what will dictate how many worker hours a profit maximizing firm should hire? (i.e., at what point should a firm choose to not hire another hour of labor?)

Mathematically?

Labor Demand Function

What is a labor demand function?

So in the ‘short-run”, what will determine its shape?

Labor Demand

Now consider longer-run, where firms are able to substitute other inputs (i.e. machines, foreign labor, labor in other cites) for local labor?

What will firms do as local wage rises?

Will this generally steepen or flatten labor demand curve?

Labor Demand

So what are key assumptions behind a downward sloping labor demand curve?

How does slope change over time?

Why is this slope important?

Labor Demand

Demand Elasticity – Ratio of the percentage change in labor demanded due to a 1% change in the market wage.

How does this relate to demand curve?

So consider demand elasticity in different sectors: Demand for Computer programmers

Demand for Fast-food workers

Labor Demand

If price of labor rises, what else can firms potentially do besides decrease its usage of labor and alter input mix? (consider industries where labor is only input and demand for labor is pretty inelastic, e.g. retail or hotels)

Why is output price change less likely than demand change though?

Labor Supply

Now consider labor supply, or how workers react to changes in wages.

To do so, let us first consider an individual who owns an apple tree and likes apples.

What can he do with his apples?

How will his supply of apples to the market change as the price he can sell apples for rises?

How will his supply of apples to the market change if his non-apple income rises?

Labor Supply

Now instead of apples, let us first consider an individual who is endowed with time.

What can he do with his time?

How will his supply of time to the labor market change as the price such time could be sold for in the labor market rises?

How will his supply of time to the labor market change if his non-labor income rises?

Labor Supply

So our simple model of labor supply says:1. As effective wage rises, more labor should be

supplied (equivalently, as effective wage falls, less labor should be supplied). Graphically?

2. As non-labor income rises, less labor should be supplied at any given wage rate (equivalently, as non-labor income falls, more labor should be supplied at any given wage rate). Graphically?

Labor Market Equilibrium

So in a competitive market, what will determine “equilibrium” wage?

Labor Market Equilibrium

Suppose demand for assembly workers in a town increases due to a new factory moving in. What will happen to wages for assembly workers in short-run?

How will happen to wages for assembly workers in longer-run?

Labor Demand

Is the assumption that markets are competitive reasonable? What would be alternative and how would that impact our model?

Labor Market Theory and Minimum Wage

What does our model say will happen in a given industry if a minimum-wage is imposed?

What if some “sectors” are covered and others aren’t?

Labor Market Equilibrium

What is key facet of the model that leads to this implication that employment falls the higher the minimum wage?

So what does size of employment effect of minimum wage depend on?

Labor Market Equilibrium

Now, consider a sector with a pretty inelastic labor demand.

If a minimum wage is imposed, employment might not be very affected, but are there other concerns?

Labor Market Equilibrium

What about a different kind of labor market intervention. Suppose we required employers to pay for worker’s health insurance.

Suppose most workers would buy health insurance if offered at what employers pay for it. What is now “effective wage” faced by employers and workers?

So how do labor demand and labor supply curves change when plotted against “nominal wage”?

What happens to employment, nominal wages, and effective wages?