INSTRUCTOR'S MANUAL

to accompany

Ehrenberg & Smith

Modern Labor Economics:

Theory & Public Policy

Eighth Edition

Robert S. Smith

Cornell University

Robert M. Whaples

Wake Forest University

Lawrence Wohl

Gustavus Adolphus University

Copyright 2003 Addison-Wesley, Inc.

All rights reserved. Printed in the United States of America. No part of this book may be used

or reproduced in any manner whatsoever without written permission from the publisher, except

testing materials and transparency masters may be copied for classroom use. For information,

address Addison-Wesley Higher Education, Pearson PLC 75 Arlington Street, Suite 300,

Boston, Massachusetts 02116.

A NOTE TO THE INSTRUCTOR

This Instructor's Manual is intended to summarize the content of the eighth edition of Modern

Labor Economics: Theory and Public Policy in a way that explains our pedagogical strategy.

Summarized briefly, we believe that labor economics can be best learned if students are (1) able

to see the "big picture" early on, so that new concepts can be placed in perspective; (2) moved

carefully from concepts they already know to new ones; (3) motivated by seeing the policy

implications or inherently interesting insights generated by the concepts being taught. To this

last end, we discuss policy issues in every chapter and, in addition, employ "boxed examples" to

demonstrate in historical, cross-cultural, or applied managerial settings the power of the

concepts introduced.

The text is designed to be accessible to students with limited backgrounds in economics. We do

employ graphic analyses and equations as learning aids in various chapters; however, we are

careful to precede their use with verbal explanations of the analyses and to introduce these aids

in a step-by-step fashion. To help students in the application of concepts to various issues, we

have printed answers to the odd-numbered review questions for each chapter at the back of the

book.

We have also endeavored to put together a text that, while accessible to all, is a comprehensive

and up-to-date survey of modern labor economics. There are 9 chapter appendices designed to

be used with more advanced students in generating additional insights.

In the first part of this Instructor's Manual, we present a brief overview and the general plan of

Modern Labor Economics. We then present a chapter-by-chapter review of the concepts

presented in the text. In the discussion of each chapter we list the major concepts or

understandings covered, and in some cases suggest topics or sections that could be eliminated if

time must be conserved. We also present our answers to the even-numbered review questions at

the end of each chapter.

An important part of this Instructor's Manual are the suggested essay questions related to each

chapter. We present a few suggested essay questions for each chapter.

Table of Contents

Click on the chapter title to jump directly to that page.

Overview of the Text 1

Chapter 1 Introduction 4

Chapter 2 Overview of the Labor Market 8

Chapter 3 The Demand for Labor 14

Chapter 4 Labor Demand Elasticities 20

Chapter 5 Quasi-Fixed Labor Costs and Their Effects on Demand 26

Chapter 6 Supply of Labor to the Economy: The Decision to Work 32

Chapter 7 Labor Supply: Household Production, the Family, and the Life Cycle 37

Chapter 8 Compensating Wage Differentials and Labor Markets 45

Chapter 9 Investments in Human Capital: Education and Training 51

Chapter 10 Worker Mobility: Migration, Immigration, and Turnover 57

Chapter 11 Pay and Productivity 62

Chapter 12 Gender, Race, and Ethnicity in the Labor Market 68

Chapter 13 Unions and the Labor Market 77

Chapter 14 Inequality in Earnings 84

Chapter 15 Unemployment 88

1

OVERVIEW OF THE TEXT

INTRODUCTION/REVIEW: Chapters 1 and 2

Chapter 1 - Introduction

Appendix 1A - Statistical Testing of Labor Market Hypotheses

Chapter 2 - Overview of the Labor Market

Chapters 1 and 2 introduce basic concepts of labor economics. They are written to be

accessible to students without backgrounds in intermediate theory, and can, therefore, be

used as building blocks when a professor must "begin at the beginning." If the course is

being taught to economics majors with intermediate microeconomics as a prerequisite,

these chapters may be skipped or skimmed quickly as a review.

An appendix to Chapter 1 introduces the student to econometrics. The purpose of this

appendix is to present enough of the basic econometric concepts and issues to permit

students to read papers employing ordinary least squares regression techniques. We

strongly recommend assigning Appendix 1A in courses requiring students to read

empirical papers in the field. We also recommend (in footnote 3 of the appendix) an

introductory econometrics text that could be assigned by instructors who wish to go

beyond our introductory treatment.

THE DEMAND FOR LABOR: Chapters 3-5

Chapter 3 - The Demand for Labor

Appendix 3A - Graphic Derivation of a Firm's Labor Demand Curve

Chapter 4 - Labor Demand Elasticities

Appendix 4A - International Trade and the Demand for Labor: Can High-

Wage Countries Compete?

Chapter 5 - Quasi-Fixed Labor Costs and Their Effects on Demand

The demand for labor is discussed first primarily because we believe that the supply of

labor is a more complex topic in many ways. Before analyzing the labor/leisure choice

and household production, we first introduce students to the employer side of the market.

For instructors who desire to cover topics concerned with the decision to work first,

however, we note that Chapters 6 and 7, which deals with that decision, are self-

contained. Therefore, nothing would be lost if Chapters 6 and 7 were taught ahead of

Chapters 3, 4, and 5.

In Chapter 3 the principal question analyzed is why demand curves slope downward. In

Chapter 4 we move to a discussion of the elasticity of demand, and analyze the

determinants of the precise relationship between wages and employment. The concepts

are used to analyze how technological change and foreign trade affect labor demand.

Finally, Chapter 5 analyzes the quasi-fixed nature of many labor costs and the ways these

costs affect the demand for labor.

2

SUPPLY OF LABOR TO THE ECONOMY: Chapters 6 and 7

Chapter 6 - Supply of Labor to the Economy: The Decision to Work

Chapter 7 - Labor Supply: Household Production, the Family, and the Life Cycle

Chapters 6 and 7 analyze the decision of an individual to work for pay. The traditional

analysis of the labor/leisure choice is given in Chapter 6, while in Chapter 7 the decision

to work for pay is placed in the context of household production. The essential features

of the decision to work for pay are included in Chapter 6. In one-quarter courses or

courses in which time is scarce, Chapter 7 could be skipped; however, doing so would

eliminate analyses of family labor supply decisions as well as labor supply decisions in

the context of the life cycle.

As noted above, Chapters 6 and 7 are designed to be self-contained for the convenience

of instructors who wish to teach labor supply ahead of labor demand.

FACTORS AFFECTING THE CHOICE OF EMPLOYMENT: Chapters 8-10

Chapter 8 - Compensating Wage Differentials and Labor Markets

Appendix 8A - Compensating Wage Differentials and Layoffs

Chapter 9 - Investments in Human Capital: Education and Training

Appendix 9A - A "Cobweb” Model of Labor Market Adjustment

Appendix 9B - A Hedonic Model of Earnings and Educational Level

Chapter 10 - Worker Mobility: Migration, Immigration, and Turnover

Once they have decided to seek employment, prospective workers encounter important

choices concerning their occupation and industry, as well as the general location of their

employment. Chapters 8 through 10 analyze these choices, with Chapters 8 and 9

focusing on industry/occupational choice and Chapter 10 on the choice of a specific

employer and the location of employment. More particularly, Chapter 8 presents an

analysis of job choice within the context of jobs that differ along nonpecuniary

dimensions. Chapters 9 and 10 analyze issues affecting worker investments in skill

acquisition (Chapter 9) and job change (Chapter 10), and both employ the concepts of

human capital theory. All three chapters contain appendices of interest to instructors who

wish to teach more advanced material.

ANALYSES OF SPECIAL TOPICS IN LABOR ECONOMICS: Chapters 11-15

Chapter 11 - Pay and Productivity

Chapter 12 - Gender, Race, and Ethnicity in the Labor Market

Appendix 12A - Estimating "Comparable Worth" Earnings Gaps: An

Application of Regression Analysis

Chapter 13 - Unions and the Labor Market

Appendix 13A - Arbitration and the Bargaining Contract Zone

3

Chapter 14 - Inequality in Earnings

Appendix 14A - Lorenz Curves and Gini Coefficients

Chapter 15 - Unemployment

Having presented basic concepts and analytical tools necessary to understand the demand

and supply sides of the labor market, we now move to analyses of special topics:

compensation, discrimination, unions, inequality, and unemployment. A complete

analysis of all these topics requires an understanding of behavior on both the demand and

supply sides of the market, and these chapters are built upon the preceding ten. No new

analytical tools are introduced in these chapters.

The chapters on unionism (Chapter 13) and discrimination (Chapter 12) deal with issues

typically covered in labor economics courses, but they are more comprehensive than

most other texts. It should be noted that the appendix to Chapter 12 includes an

application of regression analysis. The chapter on inequality is unique and can be skipped

without a loss in coverage of conventional material; however, it is written in a way that

provides a review of material in previous chapters.

4

CHAPTER 1 - INTRODUCTION

Because the textbook stresses economic analysis as it applies to the labor market,

students must understand the ways economic analyses are used. The basic purpose of

Chapter 1 is to introduce students to the two major modes of economic analysis: positive

and normative. Because both modes of analysis rest on some very fundamental

assumptions, Chapter 1 discusses the bases of each mode in some detail.

In our treatment of positive economics, the concept of rationality is defined and

discussed, as is the underlying concept of scarcity. There is, in addition, a lengthy

discussion of what an economic model is, and an example of the behavioral predictions

flowing from such a model is presented. The discussion of normative economics

emphasizes its philosophical underpinnings and includes a discussion of the conditions

under which a market would fail to produce results consistent with the normative criteria.

Labor market examples of governmental remedies are provided.

The appendix to Chapter 1 introduces the student to ordinary least squares regression

analysis. It begins with univariate analysis, introduced in a graphical context, explaining

the concepts of dependent and independent variables, the "intercept" and "slope"

parameters, the "error term," and the t statistic. The analysis then moves to multivariate

analysis and the problem of omitted variables.

List of Major Concepts

1. The essential features of a market include the facilitation of contact between buyers

and sellers, the exchange of information, and the execution of contracts.

2. The uniqueness of labor services affects the characteristics of the labor market.

3. Positive economics is the study of economic behavior, and underlying this theory of

behavior are the basic assumptions of scarcity and rationality.

4. Normative economics is the study of what "should be," and theories of social

optimality are based in part on the underlying philosophical principle of "mutual

benefit. "

5. A market "fails" when it does not permit all mutually beneficial trades to take place,

and there are three common reasons for such failure.

6. A governmental policy is "Pareto-improving" if it encourages additional mutually

beneficial transactions. At times, though, the goal of improving Pareto efficiency

conflicts with one of generating more equity.

7. The concept that governmental intervention in a market may be justified on grounds

other than the principle of mutual benefit is discussed (for example, government

5

intervention may be justified on the grounds that income redistribution is a desirable

social objective).

8. (Appendix) The relationship between two economic variables (e.g., wages and quit

rates) can be plotted graphically; this visual relationship can also be summarized

algebraically.

9. (Appendix) A way to summarize a linear relationship between two variables is

through ordinary least squares regression analysis -- a procedure that plots the "best"

line (the one that minimizes the sum of squared deviations) through the various data

points. The parameters describing this line are estimated, and the uncertainty

surrounding these estimates are summarized by the standard error of the estimate.

10. (Appendix) Multivariate procedures for summarizing the relationship between a

dependent and two or more independent variables is a generalization of the univariate

procedure, and each coefficient can be interpreted as the effect on the dependent

variable of a one-unit change in the relevant independent variable, holding the other

variables constant.

11. (Appendix) If an independent variable that should be in an estimating equation is left

out, estimates of the other coefficients may be biased away from their true values.

Answers to Even-Numbered Review Questions

2. Are the following statements "positive" or "normative"? Why?

a. Employers should not be required to offer pensions to their employees.

b. Employers offering pension benefits will pay lower wages than they would if they did

not offer a pension program.

c. If further immigration of unskilled foreigners is prevented, the wages of unskilled

immigrants already here will rise.

d. The military draft compels people to engage in a transaction they would not

voluntarily enter into; it should therefore be avoided as a way of recruiting military

personnel.

e. If the military draft were reinstituted, military salaries would probably fall.

Answer: (a) normative (b) positive (c) positive (d) normative (e) positive

4. What are the functions and limitations of an economic model?

Answer: The major function of an economic model is to strip away real world

complexities and focus on a particular cause/effect relationship. In this sense an

economic model is analogous to an architect's model of a building. An architect may be

interested in designing a building that fits in harmoniously with its surroundings, and in

designing such a building the architect may employ a model that captures the essentials

of his or her concerns (namely, appearance) without getting into the complexities of

6

plumbing, electrical circuits, and the design of interior office space. Similarly, an

economic model will often focus on a particular kind of behavior and ignore complexities

that are either not germane to that behavior or only of indirect importance.

Models used to generate insights about responses to a given economic stimulus are often

not intended to forecast actual outcomes. For example, if we are interested in bow

behavior is affected by stimulus B, with factors C, D, and E held constant, our model

may not correctly forecast the observed behavior if stimuli C through E also change.

6. A few years ago it was common for state laws to prohibit women from working more

than 40 hours a week. Using the principles underlying normative economics, evaluate

these laws.

Answer: Laws preventing women from working more than 40 hours per week essentially

blocked mutually beneficial transactions. There were women who wanted to work more

than 40 hours a week, and there were employers who wanted to employ them for more

than 40 hours a week. The restrictions upon their employment prevented these

transactions from occurring and therefore made both the women and their potential

employers worse off.

8. “Government policies as frequently prevent Pareto efficiency as they enhance it.”

Comment.

Answer. Achieving Pareto efficiency requires the completion of all mutually beneficial

transactions. Ideally, government would step in to provide information is that is blocking

mutually beneficial transactions or to establish markets (or market substitutes) when

markets do not exist. However, governments also have power to prevent transactions or

distort prices, both of which can prevent the completion of mutually beneficial

transactions. Government regulations can outlaw certain transactions that the parties to

them would consider mutually beneficial (the text mentions laws that historically

prevented women from working more than 40 hours per week). Government also has the

power to distort prices by setting minimum wages, mandating premiums for overtime

work, and so forth.

Answers to Even-Numbered Problems

2. (Appendix) Suppose that a least squares regression yields the following estimate:

Wi = -1 + .3Ai, where W is the hourly wage rate (in dollars) and A is the age in years.

A second regression from another group of workers yields this estimate:

Wi = 3 + .3Ai - .01(Ai)2.

a. How much is a 20-year-old predicted to earn based on the first estimate?

b. How much is a 20-year-old predicted to earn based on the second estimate?

Answer: a. W = -1 + .3x20 = 5 dollars per hour.

b. W = 3 + .3x20 - .01x20x20 = 3 + 6 - 4 = 5 dollars per hour.

7

Suggested Essay Questions

1. Child labor is an issue that has been discussed a lot recently. From the perspective of

normative economics, explain the problem with child labor.

Answer: Pareto efficiency requires that transactions have mutual benefits, and this can be

assured only if the transactions are voluntary and take place with complete information.

Children may be compelled by their parents to work, and they have limited capacities to

make informed decisions even in the absence of compulsion.

2. A law in one town of a Canadian province limits large supermarkets to just four

employees on Sundays. Analyze this law using the concepts of normative economics.

Answer. There are no doubt large supermarkets that want to hire workers on Sundays

(because there are consumers who want to shop on Sundays), and there are no doubt

employees who could be induced – perhaps by higher wages – to work on Sundays. A

law preventing such work prevents a mutually beneficial transaction.

8

CHAPTER 2 - OVERVIEW OF THE LABOR MARKET

Our goal in this text is to move students along very carefully from what they do know to

the mastery of new concepts. It is our belief that students learn most efficiently if they

can associate these new ideas with an overall framework, and it is the purpose of Chapter

2 to provide that framework. This chapter has both a descriptive and an analytical

purpose. One aim is to introduce students to the essential concepts, definitions,

magnitudes, and trends of widely used labor market descriptors. To this purpose, the

chapter discusses and presents data on such topics as the labor force, unemployment, the

distribution of employment, and the level of (and trends in) labor earnings. The second

aim is to provide students with an overview of labor market analysis. To this end, we

discuss basic concepts of demand and supply so that students will be able to see their

interaction at the very outset.

We start the overview with a discussion of demand schedules and their corresponding

demand curves. Particular attention is given to the distinction between movement along a

curve and shifts of a curve. Distinctions between individual and more aggregated demand

curves are discussed, as is the distinction between short-run and long-run demand curves.

A similar discussion and set of distinctions are made for the supply side of the market.

After both the demand and supply sides of the market have been discussed and generally

modeled, we turn to the question of wage determination and wage equilibrium. Forces

that can alter market equilibria are comprehensively discussed, and the chapter's major

concepts are reinforced by discussions of the effects of unions, the existence of

disequilibrium, and the concept of being "overpaid" or "underpaid" (including a

discussion of economic rents). The chapter ends with a discussion of unemployment

across various countries.

List of Major Concepts

1. The labor market and its various subclassifications (national, regional, local; external,

internal; primary, secondary) are defined.

2. The "labor force" consists of those who are employed or who are seeking work, and

major trends in labor force participation rates are discussed.

3. The "unemployed" are those who are not employed but are seeking work (or awaiting

recall); trends in the unemployment rate are noted.

4. Changes in the industrial and occupational distribution of employment are facilitated

by the labor market, which also facilitates adjustments to the "birth" and "death" of

job opportunities.

5. The distinction between nominal and real wage rates is made, and the calculation of

real wages is illustrated.

9

6. Distinctions among wage rates, earnings, total compensation, and income are

depicted graphically.

7. The labor market is one of three major markets with which an employer must deal; in

turn, labor market outcomes (terms of employment and employment levels) are

affected by both product and capital markets.

8. The concepts underlying a labor demand schedule are associated with product

demand, the choice of technology, and the supply schedule of competing factors of

production; scale and substitution effects are ultimately related to these forces.

9. Underlying a supply schedule for labor are the alternatives workers have and their

preferences regarding the job's characteristics.

10. Distinctions between individual and market demand and supply curves are discussed.

11. Movements along, rather than shifts of, demand and supply curves occur when wages

of the job in question change; when a variable not shown on the graph changes, the

curves tend to shift.

12. The interaction of market demand and supply determines the equilibrium wage.

13. Changes in the equilibrium wage rate are caused by shifts in either the demand or

supply curves. Disequilibium will persist if the wage is not allowed to adjust to shifts

in demand or supply.

14. The concepts of "overpaid" and "underpaid" compare the actual wage to the

equilibrium (market) wage rate.

15. Individuals paid more than their reservation wage are said to obtain an "economic

rent."

16. The concepts of shortage and surplus are directly related to the relationship between

actual and equilibrium wage rates.

17. Unemployment rates, and especially long-term unemployment rates, have risen in

Europe relative to the United States and Canada over the recent decade; this rise may

reflect the existence of relatively stronger nonmarket forces in Europe.

Answers to Even-Numbered Review Questions

2. Analyze the impact of the following changes on wages and employment in a

given occupation:

a.) A fall in the danger of the occupation.

b.) An increase in product demand.

10

c.) Increased wages in alternative occupations.

Answer: (a) A fall in the danger of the occupation, other things being equal, should

increase the attractiveness of that occupation, shifting the supply curve to the right and

causing employment to rise and wages to fall.

(b) An increase in product demand will shift the demand for labor curve to the right

causing both wages and employment to increase.

(c) Increased wages in other occupations will render them relatively more attractive than

they were before and cause the supply curve to the occupation in question to shift to the

left. This will cause employment in this market to fall and wages to rise.

4. Suppose a particular labor market were in market-clearing equilibrium. What could

happen to cause the equilibrium wage to fall? If all money wages rose each year, how

would this market adjust?

Answer: Starting from the position of equilibrium, a labor market could experience a fall

in the equilibrium wage if either the demand curve shifts to the left or the supply curve

shifts to the right. While market wages are usually stated in nominal terms, their

relationship to the prices of both consumer and producer products is of ultimate

importance. Therefore, both parties to the employment relationship are, in the last

analysis, concerned with the real wage rate. The real wage rate can fall when the nominal

wage rate is rising if prices of consumer and producer products rise even more quickly.

6. How will a fall in the civilian unemployment rate affect the supply of recruits for the

volunteer army? What will be the effect on military wages?

Answer: Supply curves to a given occupation are drawn holding alternative opportunities

constant. If those opportunities become more attractive, the supply curve to the given

occupation will shift left and tend to drive up wages. Thus, a fall in the unemployment

rate will shift the army's supply curve to the left (there will be fewer recruits at each army

wage rate), and the army's wages will be driven up.

8. Suppose that the Consumer Product Safety Commission issues a regulation requiring

an expensive safety device to be attached to all power lawnmowers. This device does

not increase the efficiency with which the lawnmower operates. What, if anything,

does this regulation do to the demand for labor of firms manufacturing power

lawnmowers? Explain.

Answer: This regulation would cause the demand for labor curve of the firms that

manufacture power mowers to shift to the left. The demand for labor is in part derived

from product demand. Because it is more costly now to manufacture lawnmowers, the

prices that will be charged to consumers will rise. This price increase will move the firm

upward and to the left along its product demand curve. With less product demanded for

any given wage rate paid to workers, the end result is a leftward shift of the labor demand

11

curve. (If, however, consumer preferences for greater safety were to shift the product

demand curve to the right, employment losses would be mitigated.)

10. Suppose we observe that employment levels in a certain region suddenly decline as a

result of (i) a fall in the region's demand for labor, and (ii) wages that are fixed in the

short run. If the new demand for labor curve remains unchanged for a long period and

the region's labor supply curve does not shift, is it likely that employment in the

region will recover? Explain.

Answer: The initial response to a leftward shift in the labor demand curve in the context

of fixed wages is for there to be a relatively large decline in employment. This decline in

employment is larger than the ultimate decline in employment. The initial disequilibrium

between demand and supply in the labor market should force wages down in the long run,

and as wages decline firms will move downward along their labor demand curves and

will begin to employ more labor. However, employment in the region would recover to

its prior level (assuming no subsequent shifts in demand or supply curves) only if the

supply curve was vertical; if supply curves are upward-sloping, the declining wage will

cause some withdrawal of labor from the market and employment will not recover to its

prior level.

Answers to Even-Numbered Problems

2. Suppose that the supply curve for school teachers is Ls = 20,000 + 350W and the

demand curve for school teachers is Ld = 100,000 – 150W, where L = the number of

teachers and W = the daily wage.

a. Plot the demand and supply curves.

b. What are the equilibrium wage and employment level in this market?

c. Now suppose that at any given wage 20,000 more workers are willing to work as

school teachers. Plot the new supply curve and find the new wage and employment

level. Why doesn't employment grow by 20,000?

Answer: a. See the figure. Plot the Ld and Ls curves by solving for desired employment

at given wage rates. If W = 500, for example, employers desire 25,000 workers (Ld =

100,000 – 150x500); if W = 400, they would desire 40,000. Since the equation above is

for a straight line, drawing a line using these two points gives us the demand curve. Use

the same procedure for the labor supply curve.

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b. To find the equilibrium, solve for the wage at which the quantity of labor supplied

equals the quantity of labor demanded: Ls = 20,000 + 350W = 100,000 – 150W = Ld.

Solve for W by adding 150W to both sides and subtracting 20,000 from both sides to

yield 500W = 80,000. Dividing both sides by 500 reveals that W = $160 per day.

Plugging W = $160 into both the labor demand and supply equations shows that L =

76,000 schoolteachers.

c. The new labor supply curve is Ls' = 40,000 + 350W. Setting this equal to Ld and

solving shows that W = $120 per day; L = 82,000 school teachers. Employment doesn't

grow by 20,000 because the shift in the supply curve causes the wage to fall, which

induces some teachers to drop out of the market.

Suggested Essay Questions

1. American students have organized opposition to the sale by their campus stores of

university apparel made for American retailers by workers in foreign countries who

work in “sweatshop” conditions (long hours at low pay in bad working conditions).

Assume this movement takes the form of boycotting items made under sweatshop

conditions.

13

(a) Analyze the immediate labor market outcomes for sweatshop workers in these

countries, using demand and supply curves to illustrate the mechanisms

driving this outcome.

(b) Assuming that actions by American students are the only force driving the

improvement of wages and working conditions in foreign countries, what

must these actions include to ensure that the workers they are unambiguously

better off?

Answer. (a) The demand curve for low-wage workers in foreign countries shifts to the

left when the product demand for the apparel they made falls. This drives down wages

and employment (assuming a fixed supply curve). (b) To avoid the effects in (a),

students in the U.S. must be willing to buy the same quantity and quality of apparel at

higher prices – that is, they must be willing to pay a premium for apparel made by better-

paid workers.

2. Ecuador is the world’s leading exporter of bananas, which are grown and harvested

by a large labor force that includes many children. Assume Ecuador now outlaws the

use of child labor on banana plantations. Using economic theory in its “positive”

mode, analyze what would happen to employment and wages in the banana farming

industry in Ecuador. Use demand and supply curves in your analysis.

Answer. Outlawing child labor on banana plantations reduces the supply of labor to

these plantations, shifting the supply curve to the left. With a fixed demand curve, this

shift in the supply curve drives up wages and drives down employment.

14

CHAPTER 3 - THE DEMAND FOR LABOR

This chapter studies the downward sloping nature of the labor demand curve. It begins

with a section that discusses profit maximization, and it moves deductively from the

assumption of profit maximization to the marginal conditions with respect to labor. These

conditions are expressed in simple mathematical terms, and they are also discussed

verbally. Additional insights into the marginal productivity theory of demand are

provided in a section discussing common objections to this theory of demand.

The analysis of demand begins with the assumption that both labor and product markets

are competitive; in this context, we first consider the short-run before moving on to the

long-run and the case with more than two inputs. Next we consider the demand for labor

when the product market is not competitive, and then move to an analysis of demand

when the labor market is monopsonized. In the latter context, we contrast the wage and

employment effects of "market" and "mandated" shifts in the labor supply curve.

The chapter concludes with a policy analysis of payroll taxes that demonstrates the

insights that can be derived from an understanding of the demand for labor. The principal

conceptual tool employed involves distinguishing between the wage rate employers pay

and the wages employees receive. When these two wages differ, one must be stated in

terms of the other for the demand and supply curves to be shown together. When a

payroll tax is introduced, one of the two curves must therefore shift, and there will be

related changes in both wages and employment.

The appendix to Chapter 3 is designed for students who feel comfortable using

microeconomic theory at the intermediate level. We derive the demand for labor

graphically using a two-factor model in both the long-run and short-run. Both

substitution and scale effects are graphically illustrated, and the assumptions underlying

the demand curve are more rigorously presented. Any instructors wishing to skip over the

appendix can do so without loss of concepts needed to understand the basics of the

demand for labor.

List of Major Concepts

1. The assumption of profit maximization by firms underlies the theory of labor demand.

The process of profit maximization requires considering small changes in inputs (or

outputs), and comparing the marginal revenue generated by an additional input with

its marginal expense.

2. The marginal product of labor is the added output generated by adding a unit of labor,

holding capital constant.

3. If markets are competitive, firms perceive prices as given.

4. The difference between the short-run and long-run depends on the fixity of capital.

15

5. The concept of diminishing marginal productivity is discussed.

6. The relationship between the demand for labor curve and the downward sloping

portion of a firm's marginal product of labor curve is analyzed.

7. The demand for labor can be stated in terms of either the real or the nominal wage.

8. The relationship between the demand curve of individual firms and the market

demand curve is briefly discussed.

9. Two principal objections to the marginal productivity theory of labor demand are

presented and discussed.

10. The conditions for profit maximization with respect to capital are relevant in the long-

run, and adjustments of capital to changes in relative prices generate substitution

effects on employment.

11. Generalizing to more than two inputs, the demand for one grade of labor is influenced

by the wages of other grades of labor.

12. The concepts of substitutes in production, gross substitutes, complements in

production, and gross complements are defined and related.

13. Product market monopoly affects the profit maximization conditions, and thus, the

demand for labor.

14. Monopsony in the labor market affects wages, employment, and the labor conditions

for profit maximization. The reason for this derives from the upper-sloping labor

supply curve facing the individual firm, and the resultant increase in the marginal

expense of labor above the wage rate.

15. In the context of monopsony, wage increases accompanying market shifts (to the left)

in the labor supply curve produce the conventional expectations of decreased

employment. Mandated wage increases, however, flatten the labor supply curve and

reduce the marginal expense of labor, leading to ambiguous expectations regarding

employment changes, at least in the short-run.

16. The imposition of payroll taxes on the employer will shift the demand for labor curve

(when drawn as a function of employee wages) to the left, causing worker wages

and/or employment levels to fall.

17. (Appendix) The graphical depiction of a production function is presented.

18. (Appendix) The demand for labor in the short-run is graphically derived.

16

19. (Appendix) The demand for labor in the long-run, showing both substitution and

scale effects of a wage change, is graphically illustrated.

Answers to Even-Numbered Review Questions

2. Suppose that the U.S. military is having difficulty recruiting volunteers and is

considering one of two options: raising pay or reinstating the draft system. Analyze

the opportunity costs of lost civilian production when volunteers are used as

compared to those associated with drafting civilians using some random method of

choice.

Answer. In choosing employers, pay is an important consideration. Thus, many of those

who choose a military job are those whose civilian job opportunities pay less than the

military. Conversely, many of those who choose to remain civilians are workers whose

civilian pay is higher than their military pay offer. Because profits are maximized when

workers’ marginal revenue productivities (MRPL) are equal to the wage (W), we can

assume that those with higher pay also have higher civilian MRPL. Thus, when society

relies on military volunteers, it will lose less civilian output than it would by drafting an

equal number of civilian workers randomly. (It should be noted that pay is not the only

consideration in choosing a job, and that workers are really trying to maximize utility.

Those who choose civilian life over the military will be those who would get the least

utility from performing military duties. If some of the latter are forced into the military,

there is also an opportunity cost to society of lost worker utility!)

4. Suppose that prisons historically have required inmates to perform, without pay,

various cleaning and food preparation jobs within the prison. Now suppose that

prisoners are offered paid work in factory jobs within the prison walls, and that the

cleaning and food preparation tasks are now performed by non-prisoners hired to do

them. Would you expect to see any differences in the technologies used to perform

these tasks? Explain.

Answer. When inmates were required to work without pay, their wage was essentially

zero – and we would expect that prisons to have adopted labor-intensive technologies

(using the argument inherent in equation 3.8c). When wages rise, the cost of expanding

output using labor becomes greater, and we expect prisons to adopt the use of more

capital in the production process.

6. Suppose the government were to subsidize the wages of all women in the population

by paying their employers 50 cents for every hour they worked. What would be the

effect on the wage rate women received? What would be the effect on the net wage

employers paid? (The net wage would be the wage women received less 50 cents.)

Answer: Consider a simple competitive labor market in which the demand and supply of

women are both expressed in terms of the wage received by women (which, in the

absence of any subsidy, is assumed to be equal to the wage paid by employers). Given

the demand curve, D0, and the supply curve, S0, market clearing wage and employment

levels will be W0 and E0, respectively.

17

Suppose the government now subsidizes employers by paying them 50 cents for every

hour women work. Viewed in terms of the wage received by women, the employers'

demand curve will shift up by exactly 50 cents (reflecting the fact that this amount will

be paid by the government). At the old market clearing wage received by women, W0,

the number of women employers want to hire, E2, exceeds the number who are willing to

work, E0. This puts upward pressure on the wage received by women, and this wage rises

until the excess demand for labor is eliminated. This equilibrium occurs at the wage rate

W1, and the employment level E1.

It is clear from the figure that the wage received by women increases by less than 50

cents as long as the supply of labor curve is not vertical (i.e., as long as labor supply is

responsive to wages). Indeed, the more responsive labor supply is to the wage rate, the

less the women's wage will rise. Since the wage paid by employers now equals the wage

women receive less the 50-cent subsidy, it is also clear that the wage paid by employers

declines (by 50 cents minus the increase in the wage women receive).

It is important to stress to students that one would reach identical conclusions if one

analyzed the subsidy in terms of the wage employers pay. If supply and demand curves

are drawn in terms of this variable, a 50-cent-an-hour subsidy for women would shift the

female labor supply curve down by 50 cents. At the old wage paid by employers, the

supply of female labor would now exceed the demand. Downward pressure would be

placed on the wage paid by employers and it would fall by less than 50 cents (as long as

labor supply was responsive to the wage). As a result, the wage received by women

would rise by 50 cents less the fall in the wage paid by employers.

8. In 1999, the U.S. Bureau of Labor Statistics reported that hourly compensation costs

per U.S. manufacturing worker were $19.20, while those in Mexico were $2.12.

Recognizing that the analysis leading up to equation 3.8c can be used to understand

the choices firms make between any two factors of production, explain why a

growing firm with facilities in both Mexico and the U.S. might still expand its output

using U.S. workers. (Hint: consider U.S. and Mexican workers to be substitute

factors of production.)

18

Answer. The profit-maximizing firm will choose to expand production in the least costly

way. To do so, it will continue to substitute one factor of production for another until the

costs of expanding production using the two factors are equal (see equation 3.8c). In

choosing between U.S. and Mexican workers, profit maximization means that firms will

substitute one for another until the ratio of their wages to their marginal productivities are

equal. Mexican wages may be much lower than in the U.S., but if the relative marginal

productivity of Mexican workers is even lower, firms would decide to expand output

using U.S. workers. Put differently, even though wages are lower in Mexico, the ratio of

wages to marginal productivity – which is the critical datum – could be higher there than

in the U.S.

Answers to Even-Numbered Problems

2. The marginal revenue product of labor in the local saw mill is MRPL = 20 - .5L,

where L = the number of workers. If the wage of saw mill workers is $10 per hour,

then how many workers will the mill hire?

Answer: The mill will hire workers until MRPL = W. 20 - .5L = 10 when L = 20

workers.

4. The output of workers at a factory depends on the number of supervisors hired (see

below). The factory sells its output for $.50 each, it hires 50 production workers at a

wage of $100 per day, and needs to decide how many supervisors to hire. The daily

wage of supervisors is $500 but output rises as more supervisors are hired, as shown

below. How many supervisors should it hire?

Supervisors Output (units per day)

0 11,000

1 14,800

2 18,000

3 19,500

4 20,200

5 20,600

Answer. The firm needs to compare the marginal cost to the marginal revenue of hiring

an additional supervisor. The marginal cost is always $500 for each extra supervisor.

The marginal revenue is the number of additional units produced times the price of output.

Number of Supervisors MC MR

1 $500 $.50x3800 = $1900

2 $500 $.50x3200 = $1600

3 $500 $.50x1500 = $750

4 $500 $.50x700 = $350

5 $500 $.50x400 = $200

19

The firm will hire three supervisors since the marginal revenue generated from hiring the

third supervisor exceeds $500 but the marginal revenue generated from hiring the fourth

supervisor is less than $500.

Suggested Essay Questions

1. Assume that wages for keyboarders (data entry clerks) are lower in India than in the

United States. Does this mean that keyboarding jobs in the United States will be lost

to India? Explain.

Answer. Indian data entry clerks will be substituted for American ones only if the ratio of

their wage to their marginal productivity is lower. Thus, it is not wage alone that affects

the incentives to substitute; marginal productivity is also critical.

2. American students have organized opposition to the sale by their campus stores of

university apparel made for American retailers by workers in foreign countries who

work in “sweatshop” conditions (long hours at low pay in bad working conditions).

If this movement is successful in raising pay and improving working conditions for

apparel workers in foreign countries, how will these changes abroad affect labor

market outcomes for workers in the apparel and retailing industries in the United

States? Explain.

Answer. If increased labor costs abroad are not accompanied by increases in marginal

productivity, then there will be incentives to substitute for these foreign workers (with

capital or workers elsewhere, including the United States). However, increased costs of

manufacturing university apparel also would be expected to reduce sales and the scale of

output, which will put downward pressure on employment in the American apparel and

retailing industries. The presence of both substitution and scale effects – working in

opposite directions – implies that the ultimate effect on American workers in these

industries cannot be predicted by theory alone.

3. “Despite free trade and the need to compete with American and Canadian

manufacturers, most Mexican factories continue to use outdated equipment and

inefficient (labor-using) work systems.” If true, does this indicate that, in the face of

very low wages in Mexico, plant owners there are making mistakes?

Answer. The choice of technology is affected by the marginal costs of producing using

labor (W/MPL) compared to the marginal costs of producing using capital (C/MPK).

When wages are low and capital is costly, other things equal, economic theory leads us to

expect that firms would use labor-intensive methods to produce.

20

CHAPTER 4 - LABOR DEMAND ELASTICITIES

While Chapter 3 dealt with the downward sloping nature of labor demand curves,

Chapter 4 deals with the magnitude of the employment response to a change in the wage

rate. We begin the chapter by defining and discussing the own-wage elasticity of demand.

In this regard the Hicks-Marshall laws of derived demand are explained, with each of the

four laws being related to the substitution and scale effects (concepts that were

introduced in Chapters 2 and 3).

After discussing the laws of derived demand in the context of own-wage effects, we

move to a discussion of the cross-wage elasticity of demand. Here we stress the concepts

of gross substitutability and gross complementarity (as distinguished from substitutes or

complements in production). Another section is devoted to a discussion of the empirical

evidence on both the own-wage elasticity of demand and cross-wage elasticities.

The chapter concludes with sections that apply the concepts of demand elasticity to

analyzing the effects of minimum-wage legislation and technological change. The

appendix to Chapter 4 analyzes the labor-market effects of international trade.

List of Major Concepts

1. The own-wage elasticity of demand is the percentage change in employment of a

class of labor induced by a one-percent change in the wages of that class.

2. Cross-wage elasticities of demand are the percentage change in employment of a

class of labor induced by wage changes in another class; they may be positive or

negative.

3. The four Hicks-Marshall laws of derived demand are introduced and related to the

substitution and scale effects of a wage change.

4. The concepts of gross substitutability and gross complementarity are defined and

distinguished from substitutability or complementarity in production.

5. Empirical evidence concerning the own-wage and cross-wage elasticities of demand,

based on both statistical studies and inferential analyses, is presented.

6. Standard labor demand theory predicts that an increase in the minimum wage will

result in the loss of employment.

7. Actually measuring the employment effects of minimum-wage increases requires that

we distinguish between nominal and real changes in the rate, that other things

influencing employment levels be controlled for, and that the presence of uncovered

sectors and intersectoral shifts in product demand be built into the design of the study.

21

8. The results of studies estimating the effects of minimum-wage increases are sensitive

to the specification employed, with some studies finding the "conventional" negative

effects and some finding none. Even those studies with negative employment effects

generally find labor demand elasticities that are much smaller than those summarized

earlier in the chapter.

9. It is possible that the generally small effects of minimum-wage increases are the

result of the studies' focus on short-run effects, but they might also derive from labor

markets that are characterized by monopsonistic behavior (for which theoretically

expected short-run employment effects of mandated wage increases are ambiguous).

10. Technological change in product markets can change the slope and placement of

product demand curves, thereby shifting and/or changing the elasticity of labor

demand curves.

11. The labor-demand effects of technological improvements in capital depend on

crosselasticities; in attempting to analyze the likely dominance of the substitution or

scale effect in this case, the Hicks-Marshall laws applicable to own-wage changes

cannot be slavishly applied.

12. Technological change causes total employment to be reallocated, not permanently

reduced.

13. (Appendix) International trade is based on comparative advantage, and while trade

may shift employment across industries, it is not true that trade will cause permanent

job loss in high-wage countries.

Answers to Even-Numbered Review Questions

2. Union A faces a demand curve in which a wage of $4 per hour leads to demand for

20,000 person hours and a wage of $5 per hour leads to demand for 10,000 person

hours. Union B faces a demand curve in which a wage of $6 per hour leads to demand

for 30,000 person hours, while a wage of $5 per hour leads to demand for 33,000

person hours.

a. Which union faces the more elastic demand curve?

b. Which union will be more successful in increasing the total income (wages times

person hours) of its membership?

Answer: (a) As noted in the text, the elasticity of demand for labor is not necessarily a

constant along a given demand curve. Indeed, when we speak of changes in wage rates

that are not infinitesimal, the actual value of the elasticity depends on the wage rate from

which one is starting. Given the data on union A and the formula for the elasticity of

demand, %E/%W, union A's elasticity when one increases its wage rate from $4.00 to

$5.00 is given by (20,000-10,000)/20,000 divided by ($4.00-5.00)/4.00, or (1/2)/(-1/4),

which equals -2. In contrast, when one decreases union A's wage from $5.00 to $4.00, its

elasticity is given by (10,000-20,000)/10,000 divided by (5.00-4.00)/5.00 or (-1)/(1/5) or

-5. Its elasticity over the interval $4.00 to $5.00 depends on which wage we use as a base.

22

To prevent this type of result, economists often define the average elasticity over the

wage interval W1, to W2 as

[(E2-E1,)/.5(E1,+E2)]/[(W2-W1,)/.5(W1,+W2)].

Note that this elasticity estimate does not vary with the end of the wage interval (high or

low) at which one starts. In the present question the average elasticities for union A and

union B are given by

Elas. (A): [(20,000-10,000)/15,000]/[(4.00-5.00)/4.50] = (2/3)/(-2/9) = -3

Elas. (B): [(33,000-30,000)/31,500]/[(5.00-6.00)/5.50] = -.524

Given the above data, union A faces the more elastic demand curve.

(b) One cannot say which union will be more successful in increasing its members' total

earnings. This depends upon a number of factors, including the bargaining power of the

two unions and the firms with which they deal. It is true, however, that the union with the

more elastic demand curve will suffer a larger percentage employment loss for any given

percentage increase in wages, and this is likely to reduce its incentive to push for large

wage gains. Thus, one's inclination is to say that the union facing the less elastic demand

curve is likely to be more successful in raising its members' wages.

(This answer assumes that wage/employment contracts under collective bargaining lie on

the demand-for-labor curve. As shown in the appendix to Chapter 12, this need not

always be the case.)

4. Clerical workers represent a substantial share of the U.S. work force -- over 15

percent in recent years. Concern has been expressed that computerization and office

automation will lead to a substantial decline in white-collar employment and

increased unemployment of clerical workers. Is this concern well founded?

Answer: Offices have become more computerized in recent years because the cost of

using computers has fallen relative to labor's price (the wage rate). This causes a

substitution effect, tending to shift the labor demand curve to the left for categories of

labor that are substitutes in production with capital. However, there is also a scale effect

tending to increase employment for the above categories, so we cannot tell in advance

which effect will dominate. (For labor categories that are complementary with capital in

the production process, the labor demand curve clearly shifts to the right.) Therefore, it is

not necessarily true that white-collar employment will fall; the scale effect may prevail

for many of these jobs (a dominant scale effect is more likely if product demand is elastic,

if it is difficult to substitute capital for labor, and if the share of capital in total cost is

large).

23

Even if labor demand shifts left for a particular occupational category, unemployment

will not be the long-term result unless wages are rigid. Adversely affected workers would

have to shift to other occupations and may experience some transitional joblessness, but

only if wages are rigid and employees refuse to shift to lower paying jobs will their

unemployment be permanent.

6. In 1942 the government promulgated regulations that prohibited the manufacture of

many types of garments by workers who did the sewing, stitching, and knitting in

their homes. If these prohibitions are repealed, so that clothing items may now be

made either by workers in factories or by independent contractors doing work in their

homes, what effect will repealing the prohibitions have on the labor demand curve for

factory workers in the garment industry?

Answer : Repealing the prohibitions enables garment manufacturers to substitute home

workers for factory workers. Assuming that the 1942 regulations were constraining, one

can presume that there will be at least some substitution of home workers for factory

workers; this substitution will tend to shift the labor demand curve for factory workers to

the left. However, there may be a favorable scale effect for certain factory workers

performing tasks (such as packaging and shipping) complementary with home production.

Besides the shift to the left of the labor demand curve, the new substitution possibilities

opened up by repealing the 1942 regulations should serve to make the labor demand

curve for factory workers more elastic. Just as the greater ability to substitute capital for

labor will tend to make the labor demand curve more elastic, so too will the ability to

substitute home labor for factory workers.

Answers to Even-Numbered Problems

Ed: the answer to problem 2 is to be changed:

2. Professor Pessimist argues before Congress that reducing the size of the military will

have grave consequences for the typical American worker. He argues that if one million

individuals were released from the military and were instead employed in the civilian

labor market, average wages in the civilian labor market would fall dramatically.

Assume that the demand curve for civilian labor does not shift when workers are

released from the military. First, draw a simple diagram depicting the effect of this

influx of workers from the military. Next, using your knowledge of a) the definition of

the own-wage elasticity of labor demand, b) the magnitude of this elasticity for the

economy as a whole, and c) the size of civilian employment in comparison to this flood

from the military, graph these events and estimate the magnitude of the reduction in

wages for civilian workers as a whole. Do you concur with Professor Pessimist?

Answer. Because you were asked about the effects on civilian wages as a whole, you will

probably not concur with Professor Pessimist. Own-wage elasticity of demand for labor =

%(quantity demanded)/%(wage) = (Ld/Ld)/(W/W). In this case Ld = 1 million, Ld

= about 135 million employed workers, and the own-wage elasticity of demand for labor is

24

approximately -1. Thus, -1 = (1 million/135 million)/(W/W), so W/W will be very

small -- about -1/135 (or -0.0074). This implies that wages will fall by 0.74 percent.

However, the military recruits in a very narrow segment of the labor market--

mostly high school grads who do not attend college, and who are between ages 17-21.

Thus, downsizing would have the greatest effect on this segment of the market. If there

were only 13.5 million, say, in this age group, a labor demand elasticity of –1 would yield

a wage effect of the military downsizing of closer to –7.4% on this group of the

population.

4. (Appendix) The production possibilities curve for the United States is linear and

allows it to produce a maximum of 500 million units of clothing or 300 million units

of food. The production possibilities curve for France is also linear and allows it to

produce a maximum of 250 million units of clothing or 150 million units of food.

Which good will the United States export to France?

Answer: Neither. The two countries have the same opportunity cost, so neither has a

comparative advantage in either good.

Suggested Essay Questions

1. The public utilities commission in a state lifts price controls on the sale of natural gas

to manufacturing plants and allows utilities to charge market prices (which are 30%

higher). What conditions would minimize the extent of manufacturing job loss

associated with this price increase?

Answer. This question involves the cross-elasticity of demand. A higher price of natural

gas will have a substitution effect that could favor increased employment, and a scale

effect that tends to reduce employment. Factors that minimize the extent of job loss are

those that make for a robust substitution effect and a small scale effect. A large

substitution effect will tend to occur if labor is easily substituted for natural gas in the

production process, and if the supply of labor is relatively elastic. A small scale effect

would be created if natural gas is a small part of the overall cost of production, and if the

demand for the products made using natural gas is relatively inelastic.

2. One anti-terrorism expert proposes the development of two capabilities that would

protect shipments of hazardous materials by truck. One is to maintain continuous

satellite monitoring of all such shipments, and the other is to install devices that

automatically shut down any truck that has been hijacked or deviates from its

approved route. Discuss how implementing this proposal is likely to affect the

demand for truck drivers, noting especially the conditions under which this effect is

likely to be largest.

Answer. This proposal is an attempt to monitor truck drivers, and it really raises the cost

of labor (trucks now require both a driver and monitoring equipment). Thus, the four

factors underlying the elasticity of labor demand are relevant. Where it is easier to

substitute capital for labor, then trucks will tend to get bigger and the number of drivers

25

needed will go down more. The substitution effect will also be larger if the supply of

capital (in the form of larger trucks) is elastic. If product demand is more elastic, the scale

effect will be larger and product demand will go down more. Finally, where the

monitoring equipment represents a larger share of overall cost, the scale effect will be

larger.

3. (Appendix). One observer of the North American Free Trade Agreement (NAFTA)

claims that, contrary to expectations, jobs in Mexican agriculture have been destroyed

while jobs in the industrialized cities of northern Mexico have expanded. Assuming

the facts on job loss and employment gains are accurate, are they consistent with

economic theory?

Answer. Free trade allows countries to specialize in producing goods and services that

have the lowest internal opportunity cost (that is, to specialize in goods for which they

have a comparative advantage). If we think of two generalized goods (agricultural goods

and manufactured goods), a country becomes more efficient in the production of

manufactured goods will, by the definition of opportunity cost, become less efficient in

the production of agricultural goods. If Mexico has a comparative advantage in the

production of manufactured goods, it must have a comparative disadvantage in the

production of agricultural goods. Thus, the assumed facts in the question are quite

consistent with economic theory.

26

CHAPTER 5 - QUASI-FIXED LABOR COSTS AND THEIR

EFFECTS ON DEMAND

This chapter is designed to analyze the effects of quasi-fixed costs on the demand for

labor. We begin the chapter with a descriptive section on the magnitude and growth of

nonwage labor costs, because the quasi-fixed costs of labor are generally nonwage in

nature. In this section we discuss employee benefits (not all of which are quasi-fixed in

nature), and we also introduce the concept of hiring and training costs.

One implication of the existence of both variable and quasi-fixed labor costs is that there

arises a trade-off between increasing employment through hiring added workers and

increasing employment through hiring workers for longer hours. This trade-off is

discussed in the second section of the chapter, and the importance of distinguishing

between employment and hours is highlighted in our policy analysis of the overtime pay

premium and mandated benefits for part-time workers.

In the third major section we move from a general discussion of quasi-fixed labor costs to

an in-depth analysis of one particular kind of quasi-fixed cost: firms' labor investments.

An investment is a type of expenditure that occurs primarily in some initial period and

then does not recur. While the firm hopes to recoup the investment over a period it

expects the worker to be with the firm, the cost of investment becomes a "sunk cost."

This section analyzes the implications of these labor investment characteristics for the

demand for labor (after first introducing the concept of present value and modeling the

labor investment decision by the firm).

The fourth and fifth sections offer detailed analyses of the two principal types of labor

investments: training investments and hiring investments. In the section on training

investments the student is introduced to the notion of general and specific training, as

well as to the implications of training investments for the demand for labor. While

Chapter 9 also covers aspects of education and training, it is our belief that this

introduction to human capital theory in Chapter 5 is useful. In this chapter, as throughout

the text, we introduce particular concepts or tools as they are called for by the larger

context of analysis, because by maintaining a clear view of the overall context of analysis,

the student is better able to learn the insights that economics has to offer. In this

particular case, we deliberately chose to spread the concepts of human capital theory

across different chapters--using these concepts as necessary and maintaining the overall

substantive organization of the text (built around demand and supply).

For similar reasons, the section on hiring investments includes a discussion of credentials

and signaling, as well as an introduction to the concept of internal labor markets. These

topics are also discussed elsewhere in the text (notably in Chapters 11 and 12), but we

felt that a complete discussion of the effects of quasi-fixed costs on the demand for labor

was impossible without a discussion of these concepts. Again, we wanted to maintain the

organizational overview in the minds of the students. (We also firmly believe that

discussing concepts or phenomena in several contexts and at different points in the book

reinforces the learning process.)

27

List of Major Concepts

1. The distinction between variable and quasi-fixed labor costs is made.

2. The relative growth of wage and non-wage costs is presented.

3. The essential characteristic of an investment is that resources are expended in the

current period and returns are received later; the principal types of labor investments

that firms undertake relate to training and hiring.

4. There are both explicit and implicit costs of job training.

5. Employee benefits are categorized and the types typically received are listed.

6. The presence of quasi-fixed costs causes an employment/hours trade-off, and the firm

must determine its optimum mix of employment and hours per worker.

7. Increased overtime pay premiums that might be required under the Fair Labor

Standards Act would tend to reduce the use of overtime, but whether they increase the

number of workers employed depends on the size of the reduction in total labor hours

demanded.

8. The concept of present value and the need for discounting when economic decisions

are made in the context of several time periods are discussed.

9. The multi-period demand for labor, the way this demand is affected by investment

costs in the initial period of hire, and the way investment costs alter profit-

maximizing conditions with respect to labor are all generalizations of the single-

period analysis in Chapter 3.

10. The distinction between general and specific training is defined, and the effects of

specific training on the relationship between wages and marginal productivity is

analyzed.

11. Training investments are recouped through the creation of a "surplus" (a gap between

marginal product and wage) that also cushions the worker from layoffs over the

business cycle.

12. The presence of hiring costs induces firms to use credentials and internal labor

markets in the recruiting, selection and promotion processes.

13. Like training costs, hiring investments increase the productivity of selected job

applicants (by distinguishing among them on the basis of productivity), and they are

recouped by paying wages less than productivity.

28

Answers to Even-Numbered Review Questions

2. When plants close, firms usually must incur various costs associated with laying off

its workers, including processing necessary forms, helping them find other jobs, and

paying them severance allowances. Suppose that industry X finds itself in a much

more competitive product market than it used to face, and that firms in the industry

now have a greater probability of closing than they used to have. How might this

change affect (a) the number of employees hired in the industry, and (b) their average

hours of work?

Answer. Firing costs are quasi-fixed, because they are associated with workers, not hours

of work. When they are increased, as they are in industry X, this will induce firms to (a)

hire fewer workers, and (b) work those they hire for more hours.

4. Workers in a certain job are trained by the company, and the company calculates that

to recoup its investment costs the workers’ wages must be $5 per hour below their

marginal productivity. Suppose that after training, wages are set at $5 below

marginal productivity, but that developments in the product market quickly (and

permanently) reduce marginal productivity by $2 per hour. If the company does not

feel it can lower wages or employee benefits, how will its employment level be

affected in the short-run? How will its employment level be affected in the long run?

Explain, being sure to define what you mean by short-run and long-run!

Answer. In the short run (that is, when training investments have already been

concluded, so all that is variable is the employment levels of trained workers), marginal

revenue product still exceeds wages by $3 per hour, so it is advantageous for the

company to continue employing workers it has already trained. The company is not

making back enough to make the training be a good investment, but making back $3 per

hour is better than laying off the workers and making back nothing! Thus, workers will

not be laid off.

In the long run (that is, when the company is deciding about investing in new workers),

the $3 payback per hour is not sufficient to justify the training investment if wages

remain as they are. Thus, the firm will not hire and train new workers under the current

circumstances. Employment will fall as the firm fails to replace those who leave, and the

decline in employment will eventually serve to raise the marginal productivity of labor.

The decline in employment will stop when the marginal revenue product of labor is once

again $5 greater than the wage rate.

6. Suppose that the United States adopts a policy requiring employers to offer 600 hours

of paid leave for mothers of newly born babies. Assuming wages remain the same,

analyze the labor demand effects of mandated paid child-care leave on women of

childbearing age and on women past childbearing age.

Answer: This policy clearly increases the expected cost of employing women of

childbearing age by imposing on employers a quasi-fixed cost (equal to 600 hours of

29

normal earnings). This increased cost, with wages remaining equal, will reduce the

demand for younger women; the quasi-fixed nature of the cost implies that their

employment will fall more than their average hours of work.

For older women, for whom the costs of employment are unaffected, there will be both

scale and substitution effects. The former will tend to reduce demand for their services,

while the latter will tend to increase it. The overall effects of this policy on the demand

for older women cannot be predicted from theory alone (however, the four factors

affecting the elasticity of demand for labor can be used to analyze when the substitution

effect will be large relative to the scale effect).

8. Major league baseball teams scout and hire younger players whom they then train in

the minor leagues for a period of three to five years. Very few of their trainees

(perhaps 5%) actually make it to the major leagues, but if they do they are bound to

the team that owns their contract for a period of six years. After six years, the player

can become a "free agent" and choose any major league team on which to play.

Keeping in mind that the major league teams pay the costs of, but derive no revenues

from, their minor league teams, what would be the most important predictable effects

of allowing players to become free agents immediately upon entry into the major

leagues?

Answer: During the training period, teams are paying the salaries of their minor league

players and expending other resources on their training without receiving any revenues in

return. These costs represent investments in general training. A firm has no incentives to

offer general training at its own expense unless it can somehow tie the trainee to the firm

for a period long enough to recoup its investment expenditures. The rule under which

players are tied to the major league team owning their contract is intended to offer teams

a period over which to recoup these general training expenses.

If players were able to become free agents immediately upon making it to the major

leagues, teams that did not train these players would bid their wages up to a level equal to

their marginal productivity. Teams offering the training would therefore have no way of

recouping their investment expenditures, which can only be done by paying a wage less

than marginal productivity. Thus, with immediate free agency, teams would no longer

have incentives to scout and train their own players, and they would tend to adopt a

strategy of "raiding" players already trained by other teams. The major effect of

immediate free agency would therefore be to destroy the current minor league

arrangements for training players. The major league teams might give up their minor

league teams and rely solely on colleges for training professional baseball players.

Immediate free agency might also cause independent baseball training schools to arise,

with tuition charged directly to the trainees. A final alternative might be for the major

league baseball teams to collectively operate a minor league system that is financed by

assessing each team an equal share of the total costs of running the training operation.

30

Answers to Even-Numbered Problems

2. Suppose that a firm is considering training a worker. The worker's MPL is $100

during the training period, but rises to $200 in the post-training period. The worker's

wage is $100 during the training period, the cost of training is $50 and the discount

rate is 10%. What is the most that a profit-maximizing firm can afford to pay the

worker in the second period?

Answer: The firm will undertake the training if the discounted net benefits from the post-

training period exceed the net expense from the training period, i.e., if W0 + Z - MP0 <

(MP1 - W1)/(1 + r). Plug in the values to solve for W1 at the breakeven point. $100 + $50

- $100 = ($200 - W1)/1.1, or $50x1.1 = $200 - W1, so W1 = $145. If the post-training

wage is less than $145, the firm will make a profit.

Suggested Essay Questions

1. The manager of a major league baseball team argues: “Even if I thought Player X

was washed up, I couldn’t get rid of him. He’s in the third year of a four-year, $24-

million deal. Our team is in no position financially to eat the rest of his contract.”

Analyze the manager’s reasoning using economic theory.

Answer. A baseball team that has committed itself to a four-year contract has made an

investment, in the hopes, of course, of receiving a return. The cost has been “sunk,” so it

is of no relevance to any decision about how to use the player during the contract period.

The only thing of relevance is the player’s marginal revenue productivity as compared to

the marginal revenue productivity (less marginal cost to the team) of an alternative player.

2. One recent magazine article on economic recovery from a recession argued, “Labor

productivity growth usually accelerates in the first year of an expansion, because

firms are slow to hire new labor.” Comment.

Answer. One reason firms are slow to hire in expansions is that they are slow to lay off

workers during a recession. Workers in whom the firm has made an investment are paid

less then the value of their marginal product, so that the firm can recoup investment costs,

and this difference offers employment protection when productivity falls in a recession

(because investment costs are sunk and the firm will continue to employ a worker in the

short run as long as productivity exceeds the wage). As productivity rises during

expansion, firms will not hire workers (which involves an investment) until the gap

between productivity and wages is again large enough so that the firm can recoup

investment costs.

3. An author recently asserted, “Low wage jobs provide fewer hours of work than high-

wage jobs.” Using economic theory, is this statement likely to be correct? Why?

Answer. Low wage jobs involve less training than high wage jobs, and if the training in

high wage jobs is firm-specific, employers will want to substitute longer hours of work

31

for hiring more workers. Thus, it is consistent with economic theory for employers to

require longer hours of work for workers with more skills.

32

CHAPTER 6 - SUPPLY OF LABOR TO THE ECONOMY:

THE DECISION TO WORK

Beyond introducing some descriptive material on labor force trends in this century, the

primary purpose of Chapter 6 is to present an analysis of an individual's decision

concerning whether and for how long to work. The context of this decision is the

traditional labor/leisure choice framework and the chapter is carefully constructed to

build the concepts necessary for this analysis. The analysis begins with a section that

discusses the choice process verbally, building upon what students know concerning

product demand. It then moves to a specific analysis of the demand for leisure time

(which in this context is the obverse of the supply of labor), and introduces the concepts

of income and substitution effects (they are more rigorously dealt with later in the

context of a graphic analysis).

Our graphic analysis is intended to accomplish two ends. One is to fix and define more

precisely the concepts of income and substitution effects. The second is to equip students

with a tool necessary to analyze many policy issues affecting work incentives. A

sampling of such policies and their analyses is given in the final section of the chapter

(following a section that discusses empirical findings concerning labor supply to the

economy).

List of Major Concepts

1. Measures of aggregate labor supply generally focus on labor force participation rates

and weekly hours of work; trends in these measures are presented and discussed.

2. The relationship between the demand for leisure, the demand for other goods, and the

supply of labor is the focal point for beginning our analysis of labor supply theory.

3. The substitution effect is defined as the change in hours supplied attendant on a

change in the wage (price of leisure), holding income constant.

4. The income effect is the change in hours supplied for a given change in income,

holding the wage constant.

5. The major forces affecting labor supply are preferences, wages, and income; these

forces can be graphically depicted.

6. The five assumptions underlying indifference curves (a graphic depiction of

preferences) are discussed.

7. The incorporation of information on wages and income into the drawing of budget

constraints is illustrated.

8. Graphical analyses of the income and substitution effects are presented.

33

9. The concept of "reservation wage" is defined and illustrated graphically.

10. Empirical findings with respect to the labor/leisure choice, from both

nonexperimental cross-section data and experimental studies, are presented.

10. Analyses of the budget constraints created by several government income support

programs are presented. Analyzed are those with "skikes," those with zero net wage

rates (including those with work requirements), and those with positive effective

wage rates (as illustrated by an analysis of the Earned Income Tax Credit program).

Answers to Even-Numbered Review Questions

2. Evaluate the following quote: “Higher take-home wages for any group should

increase the labor force participation rate for that group.”

Answer. This quotation is correct, because for labor force participation decisions, the

substitution effect dominates the income effect. The strength of the income effect is

relatively weaker when the initial hours of work are smaller. When initial hours of work

are zero – as is the case when a person is out of the labor force – then the income effect is

zero if leisure is a normal good (increased resources cannot induce one to increase the

consumption of leisure, since leisure hours are already at their maximum).

4. The way the workers' compensation system works now, employees permanently

injured on the job receive a payment of $X each year whether they work or not.

Suppose the government were to implement a new program in which those who did

not work at all got $0.5X but those who did work got $0.5X plus workers'

compensation of 50 cents for every hour worked (of course, this subsidy would be in

addition to the wages paid by their employers). What would be the change in work

incentives associated. with this change in the way workers' compensation payments

are calculated?

Answer: This change in workers' compensation has two effects. First, it reduces the

subsidy for people who do not work from $X to $0.5X. This reduction in income by itself

would produce an income effect that tends to induce the injured worker to work more (he

or she is poorer if not working than under the previous workers' compensation system).

On the other hand, for those who work, the wage rate is increased by 50 cents an hour.

(We assume here that the change in workers' compensation payments is not so large as to

influence market wages.) The increased wage by itself would tend to induce injured

workers to work more because the cost of leisure has risen by 50 cents an hour; however,

the eventual outcome is theoretically unclear.

The effects of these changes can be seen in the figure below.

34

Along segment DE there is a clear-cut strengthening of work incentives. Segment DE has

a steeper slope than the previous budget constraint (BQ and it also lies to the southwest of

BC. Thus, along segment DE there is a substitution effect inducing more work and an

income effect that also induces more work. To the left of point E, however, along

segment EF, there are income and substitution effects that work in opposite directions.

Along segment EF the 50-cents-an-hour increase in the wage rate is sufficient to increase

the injured worker's income under workers' compensation, thereby creating an income

effect that reduces work incentives, other things equal. However, the substitution effect

of the increased wage continues to exert an increase in work incentives and the outcome

of the two effects is not predictable in advance.

Thus, if the tangency point between the worker's indifference curve and the full budget

constraint used to be along BC but to the right of point E, the worker faces a clear-cut

strengthening of work incentives under the new program. If, however, the worker's

tangency point along BC was to the left of point E, the new program would have an

unpredictable effect on work incentives.

6. Suppose the Social Security disability insurance (DI) program was structured so that

otherwise eligible recipients lost their entire disability benefit if they had any labor

market earnings at all. Suppose, too, that Congress was concerned about the work

disincentives inherent in this program, and that the relevant committee was studying

two alternatives for increasing work incentives among those disabled enough to

qualify for it. One alternative was to reduce the benefits paid to all DI recipients but

make no other changes in the program. The other was to maintain the old benefit

35

levels (for those who receive them) but allow workers to earn $300 a month and still

keep their benefits. Those who earn over $300 per month would lose all DI benefits.

Analyze the work incentive effects of both alternatives. (The use of graphic analyses

will be of great help to you.)

Answer: The proposal to reduce the average DI benefit may cause recipients to seek

work or it may not, depending on their preferences and the extent of the cut. Compare,

for example, cases a, b, and c below.

The proposal to allow DI recipients to keep their benefits until a certain earnings level is

reached will induce some of those now not working to work at least a little (case d).

Others may have preferences that preclude work (case e). However, some of those who

medically qualify for DI but would now work may decide to cut their hours of work (case

f). Thus, it is not clear from theory which proposal would have the stronger work

incentives.

8. The Tax Reform Act of 1986 was designed to reduce the marginal tax rate (the tax

rate on the last dollars earned) while eliminating enough deductions and loopholes so

that total revenues collected by the government could remain constant. Analyze the

36

work incentive effects of tax reforms that lower marginal tax rates while keeping total

tax revenues constant.

Answer: Reducing the marginal tax rate has the effect of increasing the wage rate,

because workers are allowed to keep more from any extra hours worked. Keeping tax

revenues constant suggests that workers' after-tax incomes also remain constant. Thus,

the Tax Reform Act tended to increase the wage while keeping workers' incomes

constant -- creating a pure substitution effect that tended to increase hours of work.

Answers to Even-Numbered Problems

2. Nina is able to select her weekly work hours. When a new bridge opens up, it cuts

one hour off Nina's commute to work. If both leisure and income are normal goods,

what is the effect of the shorter commute on Nina’s work time?

Answer. When the new bridge opened, Nina’s budget constraint shifted to the right in a

parallel fashion as the amount of available time for either work or leisure (as opposed to

commuting) was increased. This shift in her constraint created an income effect (she can

now work more and consume more leisure). Because both income and leisure are normal

goods, both would increase. The only way income can increase in this case is for her to

work more, so we must conclude that her extra hour per day from the shorter commute is

divided in some way between more work and more leisure. Therefore, she works more.

Suggested Essay Questions

1. In 2002, a French law went into effect that cut the standard workweek from 39 to 35

hours (workers got paid for 39 hours even though working 35), while at the same time

prohibiting overtime hours from being worked. (Overtime in France is paid at 25%

above the normal wage rate.) (a) Draw the old budget constraint, showing the

overtime premium after 39 hours of work. (b) Draw the new budget constraint. (c)

Analyze which workers in France are better off under the 2002 law. Are any worse

off? Explain.

Answer. In the drawing below, the old (pre-2002) constraint is ABC, where slope of BC

is 25% greater (in absolute value) than the slope of AB. The constraint created by the

new law is ADE, where earnings at D are equal to those at B, and the slope of DE is

horizontal (workers cannot get paid for more than 35 hours of work).

37

Income C B D E A

39 35 0 Hours of Work

close to B (that is, they worked close to 39 hours before), will also be better off if their

original utility-maximizing indifference curve passed below point D. However, for those

whose original utility-maximizing indifference curves passed above point D (almost

surely the case for most of those with original tangencies along BC), utility will fall under

the new law.

2. Country X cuts the income tax rates applicable to those with the highest incomes, and

it newly adopts a wealth tax – a tax that is based on the value of family assets

(personal assets, real estate and financial assets) above a certain threshold. Discuss

the likely work incentive effects of these tax changes on high-income workers.

Answer. The new law changes the constraint from ABC to ADEF.

38

F

Income C E B

D

A

Hours of Work

Clearly, the income tax rate reduction increases the slope of the budget constraint

(increases the net wage rate). If the wealth tax reduces a person’s overall command over

resources (which happens along segment DE), then work incentives are clearly

increased – wages are increased while wealth falls. If the effect of the two tax changes

serve to increase both the wage rate and the command over resources (compare segment

EC with EF), then the tax changes have an ambiguous effect on work incentives, because

the substitution and income effects have opposite effects on work incentives.

39

CHAPTER 7 - LABOR SUPPLY: HOUSEHOLD PRODUCTION,

THE FAMILY, AND THE LIFE CYCLE

Chapter 7 analyzes the labor supply decision (the decision to work for pay) in the context

of household production theory. In this chapter, the primary alternative to working for

pay is not assumed to be leisure, but household production. This framework quite

naturally leads the discussion of labor supply into the context of families, thereby raising

the issue of family labor supply decisions. Further, since one's household productivity

varies considerably across the life cycle (as, of course, do wages), the concepts of

household production also lead to a discussion of labor supply over the life cycle.

Instructors facing severe time constraints may wish to skip this chapter. The insights

provided by the analysis in Chapter 7 are refinements of the basic concepts introduced in

Chapter 6, and they do not contradict the insights or predictions of Chapter 6. However,

Chapter 7 summarizes some recent directions in which labor supply theory has been

going, and to sacrifice Chapter 7 would mean forgoing concepts and empirical work

close to the frontiers of economic analysis.

The chapter begins with an introduction to the concept that households combine time and

goods to produce commodities that are consumed at home. The graphic analysis of

household production and the choice of household production technology is shown to be

completely analogous to the graphic analysis and fundamental implications of the

labor/leisure choice discussed in Chapter 6. The household production context of the

labor supply decision, however, yields insights about that decision that go beyond those

of Chapter 6. These insights are discussed after our brief introduction to household

production theory in the first section.

In particular, we point out the tripartite choice between market work, household work,

and leisure in analyzing why the substitution effects for women might be expected to be

larger than those for men. We discuss such family labor supply decisions as who stays

home to care for children (if anyone does), whether both spouses will work for pay, and

the interdependency of the spouses' labor supply decisions. The "additional worker" and

"discouraged worker" hypotheses are also discussed in this context.

Our discussion of the life-cycle aspects of labor supply begins with the observation that

household productivity does indeed vary over the life cycle. The traditional interrupted

careers of married women cannot be explained without reference to the shifts in

household productivity that take place when children are born and as they grow older.

Labor supply over the life cycle is also affected by the way wages typically vary with age,

causing intertemporal substitution effects; in this context, we discuss the important issue

of choice of retirement age (including data on the way lifetime Social Security benefits

vary with age of retirement).

The chapter concludes with a policy analysis of "child support assurance" programs.

40

List of Major Concepts

1. The basic concepts of household production theory include the combining of goods

and time to produce commodities that yield the family utility.

2. Household commodities may be produced by time-intensive methods or by goods-

intensive methods; the method chosen is in part a function of the price placed on time.

3. The principal predictions associated with the income and substitution effects in the

labor/leisure model are unchanged in the context of the household production model.

The latter model, however, adds a third dimension of choice about time usage (market

work, household work, leisure).

4. As wages change, there will be changes in the time intensity of commodities

consumed as well as in the time intensity of household production technologies.

5. Joint household production decisions (which spouse, if either, should remain home

instead of working for pay) have yet to be completely modeled, but they must clearly

take account of the partners' marginal productivities at home and the wages they can

command in the "market."

6. The "discouraged worker hypothesis" and the "additional worker hypothesis" are

discussed in the context of household production theory.

7. Labor supply decisions over the life cycle are affected by household productivity

changes and predictable changes in wages over the life cycle that create intertemporal

substitution effects without corresponding income effects.

8. Graphic analysis of the choice of optimum retirement age is presented, emphasizing

how delaying retirement by a year can affect the present value of one's total income

over the remaining years of expected life.

9. Child support assurance programs ensure transfer payments to custodial parents based

on the age and number of children, not on income. In contrast with welfare programs,

which tend to create budget constraints with zero net wage rates, child support

assurance programs preserve incentives to engage in market work. However, for

those who worked for pay in the absence of such programs, the pure income effect

created by support assurance programs should tend to induce fewer hours of paid

work.

41

Answers to Even-Numbered Review Questions

2. A recent study of the labor force participation rates of women in the post-World War

II period notes:

Over the long run women have joined the paid labor force because of a series of

changes affecting the nature of work. Primary among these was the rise of the

clerical and professional sectors, the increased education of women, labor saving

advances in households, declining fertility rates, and increased urbanization.

Relate each of these factors to the household production model of labor supply that

was outlined in Chapter 7.

Answer: One of the central aspects of the household production model of labor supply is

the importance of the relative productivity in paid employment as compared to household

production. Increased opportunities in the clerical and professional sectors, as well as

increased educational levels, serve to increase productivity in paid employment (that is,

to increase the wage rate that women can command). Declining fertility rates tend to

reduce the productivity of hours spent at home, while the invention of labor saving

devices in household production make it easier to substitute goods purchased with cash

for time at home; both of these factors flatten the household utility isoquants (an hour of

household productivity forgone can be replaced more readily by goods purchased with

money). Increased urbanization also tended to make it easier to substitute goods for

household production. All these factors tended to raise market productivity relative to

household productivity, and some of them served to increase the strength of the

substitution effect relative to the income effect.

4. Is the following statement true, false, or uncertain? Explain.

"If a married woman's husband gets a raise, she tends to work less, but if she gets a

raise, she tends to work more."

Answer: Ignoring the question of joint labor supply decisions, if a married woman's

husband gets a raise, that raise (to her) has an income effect. This increased income

without a corresponding increase in her wage rate tends to induce her to work fewer

hours. However, if her wage rate rises, she will experience both an income and a

substitution effect, and if she already works, theory cannot predict which one is dominant.

If she is out of the labor force, a wage increase will increase her chances of labor force

participation.

The text pointed out, though, that spouses may make their labor supply decisions jointly.

For example, if the husband's wage increase caused him to work more, the wife may also

decide to work more if they are complements in household production (or consumption).

Thus, the answer to this question really depends upon whether one assumes the two

spouses have household productivities that are interdependent; if so, they must make

their labor supply decisions jointly.

42

6. Several studies have indicated that for prime-age males, the income effect of a wage

increase tends to dominate the substitution effect. Other recent studies point out that

hourly wages tend to rise over the early stages of the life cycle (the young receive

lower wages than the middle-aged) and that young males tend to work fewer hours

than middle-aged males, other things equal. Employing a theory of life-cycle

allocation of time, explain the apparent discrepancy.

Answer: Studies showing that for prime-aged males the income effect of a wage increase

tends to dominate the substitution effect look either at wage increases that have occurred

as society has become wealthier and more productive or at wage rates across individuals

in a population. In both cases there are both substitution effects and income effects of

wage changes. However, studies of the life-cycle effects of lower wages in the early

stages of one's working career with higher wages later on are examining these wage-

change effects over an individual's lifetime, holding constant the individual's expected

lifetime wealth. With these studies there is a substitution effect – leading to more work as

wages rise – but no corresponding income or wealth effects. The latter studies are in the

pure life-cycle mode of analysis, where at a given time individuals have an expected

lifetime wealth and also face predictable changes in their wage rate as they age.

8. Suppose that, under state law, the financial settlement in a divorce case that does not

involve dependent children depends upon the economic contribution each marriage

partner made up to the date of divorce. Thus, if the wife earned an income equal to

her husband's throughout the years, she would be determined to qualify for half of the

assets at the date of divorce. Based on what you have learned in Chapter 7, how could

an equitable settlement be determined in the case of a woman who stayed home,

raised the family's children, and never worked for pay?

Answer : A wife who did not work for pay nevertheless contributed to the family's

income by performing household production services that would otherwise have had to

be purchased in the market at some cost. Put differently, a woman who performs

household services saves the family money that it would otherwise have had to spend.

For a discussion of how these services can be valued, see Example 7.2.

Suggested Essay Questions

1. Assume that a state government currently provides no child care subsidies to working

single parents, but that it now want to adopt a plan that will encourage labor force

participation among single parents. Suppose that child care costs are hourly, and

suppose the government adopts a child-care subsidy that pays $3 per hour for each

hour the parent works, up to 8 hours per day. Draw a current budget constraint for an

assumed single mother (net of child care costs), and then draw in the new constraint.

Discuss the likely effects on labor force participation and hours of work.

Answer. If the old budget constraint is AB below, the new one will have a steeper slope

(reflecting a net wage that is $3 per hour higher) for the first 8 hours of work (see AC);

43

after that, the budget constraint is segment DB. Among those single parents not working

before the subsidy is adopted, the higher wage rate will tend to increase labor force

participation (the substitution effect dominates for participation decisions). For those

already working (tangencies along AC), the income effect and substitution effects of this

wage increase will have opposite tendencies on the hours of work, so the net effect is not

predictable. However, some people working over 8 hours a day before may reduce their

supply of hours and move to point C on the constraint.

Income

B D C A

8 Hours of Work

2. Assume that a state government currently provides no child care subsidies to working

single parents, but that it now want to adopt a plan that will encourage labor force

participation among single parents. Suppose child care costs are hourly, and that the

government adopts a child-care subsidy of $20 per day if the single parent works 6 or

more hours per day. Draw the current budget constraint (net of the hourly child care

costs) for an assumed single mother, and then draw in the new constraint. Discuss the

likely effects on labor force participation and hours of work.

Answer. In the drawing below, the pre-subsidy constraint is AB. The subsidy of $20

per day (CD) begins at 6 hours of work and continues for all levels of work hours beyond

6 (segment DE, which is parallel to AB). Thus, the new constraint is ACDE. Those

single parents who were out of the labor force before (maximized utility at A) and who

have very steep indifference curves will tend to remain at point A; however, those with

flatter indifference curves will find that their utility is maximized at point D. Thus, some

workers who were out of the labor force before will now join, and those who do will

44

desire jobs offering exactly 6 hours of work per day. For those along AC before

(working less than 6 hours per day), the tendency also will be to move to 6 hours of work

(although it is possible that some will have such a steep indifference curve to the left of

their tangency along segment AC that they will not be better off by working 6 hours).

For those working more than 6 hours per week before, the income effect of this subsidy

will create a tendency for them to desire fewer hours of work (as long as the hours do not

fall below 6).

Income E B D C A

6 Hours of Work

45

CHAPTER 8 - COMPENSATING WAGE DIFFERENTIALS AND

LABOR MARKETS

Chapter 8 introduces students to the concept of compensating wage differentials.

Following the practice in earlier chapters, it seeks to move students from concepts they

are familiar with to new concepts and tools. Again, the analysis begins with a verbal

exposition of occupational choice and the wage outcomes that flow from this choice

when jobs differ along nonpecuniary dimensions. Once the essential assumptions and

predictions of economic theory in this context are explained, we introduce students to a

graphic analysis that is intended to yield additional insights. The graphic analysis of the

issue of occupational choice is also intended to provide students with a tool for analyzing

the effects of government policies on the labor market.

We first apply the concepts of hedonic theory to a "bad" job injuries. Policy implications

are related to occupational safety and health legislation. We then apply the theory to an

analysis of how elements in the employment "package" on which employees place a

positive value affect the wage rate. The application in this section of the chapter relates to

the regulation of employee benefits, particularly pensions.

For those who wish to enrich the coverage in Chapter 8, we have added an appendix that

analyzes worker choice of jobs that have different probabilities of layoff. This appendix

offers another application of the theory of compensating wage differentials to an

interesting policy problem, and in so doing elucidates certain issues not commonly

understood. The analysis also introduces the student to the notions of "risk aversion" and

the willingness to pay for insurance ("certainty").

List of Major Concepts

1. In the context of full information and choice, worker behavior will generate

compensating wage differentials for job characteristics that are unpleasant or costly.

2. Compensating differentials play a dual role in allocating labor to unpleasant jobs and

in compensating those who accept unpleasant work.

3. The prediction that there will exist compensating wage differentials for unpleasant

work rests on assumptions of utility maximization, worker information, and worker

mobility.

4. Employee preferences are graphically expressed in the concavity and slope of

indifference curves.

5. Employers with different costs of eliminating unpleasant job characteristics can be

graphically represented.

6. A market equilibrium curve (or offer curve) is derived from the zero-profit isoprofit

curves of the employers in the market.

46

7. If the market is working properly, employees who are least averse to an unpleasant

job characteristic become employed with firms that find it most expensive to

eliminate that characteristic.

8. The theory of compensating differentials can only be tested using techniques that

control for other influences on job characteristics.

9. Government attempts to regulate the outcome of labor market decisions that are made

in a perfectly functioning market could lead to a reduction of utility for the workers

the government is intending to help.

10. Government intervention into the labor market can increase worker utility if the

market is not functioning perfectly (that is, if not all costs or benefits of the decision

are borne by those making them).

11. The mix of wages and benefits in the compensation package depends on both

employee preferences and the trade-offs employers are willing to make.

12. (Appendix) Some job characteristics normally considered bad may be considered

good by some workers (layoffs may be preferred if they are known in advance).

13. (Appendix) There are two issues relating to the undesirable characteristics of layoffs:

the degree to which yearly layoffs (known in advance) constrain a worker's hours of

work to lie below those otherwise desired, and the degree to which layoffs cause the

worker's income each year to fluctuate.

14. (Appendix) The concept of risk aversion is related to the hypothesis that the expected

utility of a level of income ($X) received with certainty is greater than the expected

utility of a stream of income that may fluctuate over time but yield an expected yearly

value of $X.

Answers to Even-Numbered Review Questions

2. Statement 1: "Business executives are greedy profit maximizers, caring only for

themselves." Statement 2: "It has been established that workers doing filthy,

dangerous work receive higher wages, other things equal." Can both of these

statements be generally true? Why?

Answer. Both statements can be simultaneously true. If workers are informed about job

hazards and have a choice about the jobs they take, their behavior will force even the

most greedy executives to pay higher wages for filthy, dangerous work. Even the

greediest profit maximizer must obtain a work force, and to do so must pay a wage that

workers will accept. If workers have alternative job offers that pay the same wage but

offer better working conditions, they will accept those offers and turn down work at the

more dangerous or filthy workplaces. Their behavior then will force owners to either pay

the compensating wage differentials or clean up the workplace.

47

4. Suppose highway workers in a certain city are required to give the Supervisor of

Highways an under-the-table payment of $X per year. Would you expect wages paid

to highway workers by this city to be higher or lower than the market wage? Would

you expect the salary paid by the city to its Supervisor of Highways to be above or

below market? Explain.

Answer. We would expect wages for highway workers in the city to be high relative to

the market wage. In order for workers to be attracted to highway jobs in the city they

must take home wages that are at least as great as they could obtain elsewhere. This

means that the wages they receive, less any bribes they must pay, must be at least equal

to the prevailing wage. If the Supervisor is able to extract under-the-table payments from

these workers, it is an indication that the wages paid by the city are relatively high.

Alternatively, one can look upon the bribe as an undesirable element of employment for

which the workers would have to receive a compensating wage differential.

The Supervisor's wage, by analogy, can be low relative to the market. Under-the-table

payments provide a supplement to the Supervisor's regular salary, so that even if the

Supervisor's salary is low the job may attract a satisfactory flow of applicants.

6. Suppose that Congress were to mandate that all employers had to offer their

employees a life insurance policy worth at least $50,000 in the event of death. Use

economic theory, both positively and normatively, to analyze the effects of this

mandate on employee well-being.

Answer. From the perspective of positive economics, mandating that employers offer at

least $50,000 in life insurance will obviously have no effect on those who are already

offering that much or more, but it will add to the costs of those who were previously

offering less. To be competitive in the labor market, those previously offering less must

have been compensating their workers in some other way (to make their jobs as attractive

as those of their competitors). It is thus likely that low-insurance employers were paying

higher wages than those offering more insurance. To now compete with their

competitors in the product market, the affected employers must reduce their wages (to

keep overall costs in the competitive range). Thus, the wages in firms previously offering

less insurance will decline. Of course, if wages do not, or cannot, decline by enough to

fully offset the added costs of more insurance, then employment among these employers

will fall.

From the perspective of normative economics, we would like to know if this mandate

improves the welfare of the workers affected. If the labor market is perfectly functioning,

workers are able to obtain the combination of wages and life insurance that maximizes

their utility. If the mandate forces them to take some other mix, then their utility will

decline. If the market is not allowing workers to “buy” (in the form of lower wages) the

life insurance they want, then mandating increased insurance could improve the welfare

of affected workers (as long as the mandate does not require workers to buy more than

they are willing to pay for).

48

8. "The concept of compensating wage premiums for dangerous work does not apply to

industries like the coal industry, where the union has forced all wages and other

compensation items to be the same. Because all mines must pay the same wage,

compensating differentials cannot exist." Is this statement correct? (Assume wages

and other forms of pay must be equal for dangerous and non-dangerous work and

consider the implications for individual labor supply behavior.)

Answer. This statement is not correct. To understand how the market would adjust, let us

assume that we have a set of relatively safe coal mines and a set of relatively dangerous

coal mines. Both sets of mines must pay the same wage rate and offer the same fringe

benefits.

They both advertise for help and, assuming workers quickly find out which mines are

safe and which are dangerous, the safe mines receive many more applications than the

dangerous mines. The safe mines can thus be highly selective about the applicants they

choose, and they will tend to hire the most dependable, hardest working, most motivated

employees. The dangerous mines, with very few applicants, will have to take who they

can get (those workers not chosen to work in the safe mines). Safe mines will have high

quality, highly productive workers getting wage $X, while the dangerous mines will have

lower quality workers obtaining the same wage. Thus, workers of unequal productivity

would receive the same wage, and this is tantamount to the receipt of a compensating

wage differential.

Put differently, the theory of compensating wage differentials says that people of equal

skill will receive different wages when working conditions differ. But a natural corollary

of this is that, when working conditions differ, people of different skills might receive the

same wage. In both cases workers in less desirable circumstances receive higher wages

than they would otherwise receive.

Answers to Even-Numbered Problems

2. Consider the conditions of work in perfume factories. In New York perfume factories,

workers dislike the smell of perfume, while in California workers appreciate the smell of

perfume, provided that the level does not climb above S*. (If it rises above S*, they

start to dislike it.) Suppose that there is no cost for firms to reduce or eliminate the smell

of perfume in perfume factories and assume that the workers have an alternative wage,

W*.

Draw a diagram using isocost and indifference curves that depicts the situation. (The

New York and California isocost curves are the same, but their indifference curves

differ.) What level of perfume smell is there in the New York factories? In the California

factories? Is there a wage differential between the California and New York workers?

Answer: See the figure below. The California workers are paid exactly the same as the

New York workers. This wage equals W*. The level of smell in California is S*; in New

York it is 0.

49

Suggested Essay Questions

1. A country passes a law, applying only to large firms, that cuts the standard workweek

from 39 to 35 hours (workers are paid for 39 hours even though working 35), while at

the same time prohibiting overtime hours from being worked. This law does not

apply to smaller firms in the country. (Overtime had been widespread in both sectors,

and is paid at 50% above the normal wage rate.) Using economic theory, how do you

think this law might affect wages and employment in the two sectors?

Answer. The immediate effect on workers in large firms is to give them a wage increase

of around 10% (work 35, are paid for 39), but the law also prevents them from working

overtime. How wages and employment respond depends on the value workers put on

overtime work. If they value the ability to work overtime, some in the large-firm sector

may seek jobs in the small-firm sector (where it is still possible to earn a 50% premium

for hours in excess of 39) – which would drive down wages in the small-firm sector and

drive them higher in the large-firm sector. The higher wages in the latter sector would

reflect a compensating differential for the restricted access to a valuable workplace

characteristic. However, if workers now see jobs in the large-firm sector as more

desirable than before (given the immediate wage increase and the inability of employers

to demand overtime work of their employees), then more would seek work in that sector.

In this latter case, employment shrinks and wages rise in the small-firm sector, while

employment grows and wages fall in the large-firm sector.

50

2. A recent article stated, “Workers in low-wage jobs lack the basic security, the health

benefits, and the flexibility in their work lives that most American workers take for

granted.” Assuming this statement if true, do these facts contradict the theory of

compensating wage differentials?

Answer. The theory of compensating differentials predicts that, other things equal, jobs

with low non-wage benefits would have to pay higher wages. This statement is implicitly

comparing those in low-skilled jobs with those in high-skilled jobs, where clearly “other

things” are not comparable. Thus, the facts in this statement do not contradict the theory

of compensating wage differentials.

51

CHAPTER 9 - INVESTMENTS IN HUMAN CAPITAL:

EDUCATION AND TRAINING

Chapter 9 introduces students to the concept of human capital and treats in detail

education and training investments. The chapter begins with a section on the demand for

education by workers, in which a theory of human capital investment is formulated and a

formal model of choice is presented. Implications of this model for both individual and

aggregate (market) behavior are then derived.

The second section of the chapter analyzes the relationship between education and

earnings. We introduce age/earnings profiles and discuss the reasons for their convexity.

Included in this section is an analysis of the differential convexity among such profiles

for men and women.

Next, we consider the question of whether education is a good investment. We analyze

this question from both an individual and a social perspective. The major findings of the

literature with respect to the individual rates of return to education are summarized, and

we discuss possible biases (including selection biases) inherent in these findings. When

discussing education as a social investment, we introduce both the traditional answers of

the "human capitalists" and the more agnostic views of those who see education as purely

a signaling device. In this context of evaluating education and training as investments, we

devote a section to evaluations of government job training programs.

Appendix 9A presents and explains a "cobweb" model of labor market adjustment, in

which the need for educational investments slows down the supply response to changes

in market demand. Appendix 9B presents a hedonic model of education and wages that

uses the graphic tools of Chapter 8. This hedonic model is useful in explaining several

empirical facts about the relationship between education and wages, and the discussion

also serves to integrate the concepts in Chapters 8 and 9.

List of Major Concepts

1. Investments in human beings are part of the general category of investments.

2. Investments entail costs in the current term with returns flowing in over later periods.

3. Costs of human capital investments include out-of-pocket expenses, forgone earnings,

and psychic losses.

4. Because investment returns flow in over several years, an analytical tool to convert

future sums to present value is required (the concept of present value and discounting

future sums is explained in some detail).

5. Human capital investments are more likely to be made by people who are not present

oriented, by people who are young, in situations in which the costs of human capital

52

investments are lower, and in situations in which the returns to these investments are

larger.

6. Variations in the returns to human capital investments call forth supply responses by

individuals, affecting college enrollments in predictable ways.

7. Because education is costly, jobs that require more education or training must pay a

higher wage to attract workers (that is, to compensate them for the cost of investment).

8. Age/earnings profiles are flatter for less educated workers, reflecting smaller human

capital investment costs in their early years and lower growth of productivity.

9. Post-schooling investments in on-the-job training can help account for both the

convexity and the fanning out of age/earnings profiles.

10. Post-schooling investments reduce actual earnings below potential earnings, and as

such investments decline over age, one's actual earnings approach potential.

11. Some differences between men and women in the acquisition of education and

training (including university majors) can be explained by lower rates of return to

some human capital investments among "traditional" women, who expect interrupted

labor market careers.

12. Evaluations of whether education is a good individual investment typically present

rate of return estimates that involve three sets of biases: upward biases associated

with the correlation between education and ability, downward biases associated with

the failure of monetary earnings to reflect all the benefits of a college education, and

selectivity biases arising from the fact that people who choose one career may be

more productive in that career than a comparably trained person who does not choose

that career.

13. Evaluations of whether education is a good social investment must consider the

hypothesis that education acts as a screening device, rather than an activity that

enhances productivity.

14. If the full cost of education is inversely related to ability, and if ability is positively

related to on-the-job productivity, then firms can use educational attainment as a

screening device (workers will sort themselves out according to ability in choosing

their level of educational attainment).

15. Public sector job training programs have created demonstrable earnings gains only for

adult women, and the present value of these gains typically exceed program costs.

16. (Appendix 9A) Delays in supply responses associated with the long gestation periods

of some human capital investments can create periods of oversupply followed by

periods of shortage (the "cobweb model" as it applies to the labor market).

53

17. (Appendix 9B) The hedonic model implies that those who obtain the most education

are least averse to learning and probably most able to learn quickly.

Answers to Even-Numbered Review Quesitons

2. "The vigorous pursuit by a society of tax policies that tend to equalize wages across

skill groups will frustrate the goal of optimum resource allocation." Comment.

Answer: As indicated in Chapter 1 and elsewhere, the optimum allocation of resources

requires that all mutually beneficial transactions be accomplished. If wages are forced

toward equality by government fiat, potentially beneficial human capital transactions

may be discouraged. That is, because the acquisition of training and education is costly,

human capital investments will not be undertaken unless there is a future return to them.

These returns normally are in the form of higher wages paid to those with the higher skill

levels, and if these higher wages cannot be paid, human capital investments that might

have been made will be discouraged. Thus, the pursuit of wage equalization across skill

levels will discourage human capital investment and may result in too few workers

entering skilled occupations.

4. When Plant X closed, Employer Y (which offers no training to its workers) hired

many of X’s employees after they had completed a lengthy, full-time retraining

program offered by a local agency. The city’s Equal Opportunity Commission

noticed that the workers Employer Y hired from X were all young, and it launched an

age-discrimination investigation. During this investigation employer Y claimed that

it hired all of the applicants from X who had successfully completed the retraining

program, without regard to age. From what you know of human capital theory, does

Y’s claim sound credible? Explain.

Answer. Y’s claim is consistent with human capital theory in two respects. First, its own

hiring and training costs appear to be negligible (we are told that it offers no training on

its own, and that its hiring standards consist of taking successful graduates of another

program). Because it makes no major investments in its workers, it therefore has no

reason to prefer younger workers. Second, because the retraining program to which X’s

former employees had access was “lengthy,” it may well be that only the younger

workers from X decided to invest in this retraining. All workers have to decide whether a

human capital investment opportunity will have expected benefits (properly discounted to

the present) that are at least equal to the costs, and a shorter period over which benefits

are received reduces these benefits. Thus, older workers are less likely to have decided to

invest in retraining – with the result that only the younger workers became qualified to

apply to Employer Y.

6. Suppose that the government, in an effort to upgrade the quality of mechanics,

promulgates legislation requiring all new mechanics to take three years of post-high

school training and to pass a competency test. Those who are currently mechanics

will not be subjected to these requirements. What are the likely labor market effects

54

of this legislation? Which labor and consumer groups would gain and which would

lose?

Answer: The overall effect of this requirement to license mechanics will be to reduce the

supply of mechanics and to increase their wages (average quality will rise as well.) The

labor market groups that gain are current mechanics, whose wages will be increased but

who are not subject to the licensing procedure themselves, and future mechanics of high

quality (who will not have to compete with low quality, lower cost mechanics in the

future). The labor market groups that lose include those who would have become low

cost, low quality mechanics; these potential mechanics will either be barred from the

market or will have to make training investments that they would not otherwise have

made. Put differently, the returns to training for those who would have obtained it

anyway will rise, but mandating such training will prevent some from entering the

profession and force others to undertake such training even though it might be very

costly for them in economic or psychic terms.

Among consumers, the gainers will be those who want high quality repairs and

previously had to spend time and effort to distinguish the high quality from low quality

mechanics. Losers will be poorer consumers, who may have preferred low cost, low

quality repairs to doing the work themselves, to paying the higher cost for high quality

repairs, or to having no repairs at all.

8. Many crimes against property (burglary, for example) can be thought of as acts that

have immediate gains but run the risk of long-run costs. If imprisoned, the criminal loses

income from both criminal and noncriminal activities. Using the framework for

occupational choice in the long run, analyze what kinds of people are most likely to

engage in criminal activities. What can society do to reduce crime?

Answer. Committing a crime like burglary is essentially the mirror image of a human

capital investment, because with an investment costs are borne in the present and the

returns come later. Characteristics that tend to reduce the expected costs of committing a

crime are a high discount rate (a "present orientation") and relatively poor earnings

prospects in the labor market (less to lose by being jailed).

To reduce crime society needs to reduce the immediate benefits or increase the expected

future costs of committing a crime. Reducing the benefits could be accomplished by

installing protective devices that make burglaries less likely to succeed. Increasing the

costs can be done by increasing the likelihood of catching thieves, increasing the length

of incarceration, or raising the labor-market earnings potential of those currently with the

least to lose.

Answers to Even-Numbered Problems

55

2. (Appendix) Suppose the supply curve for optometrists is given by Ls = -6 + .6W,

while the demand curve is given by Ld = 50 - W, where W = annual earnings in

thousands of dollars per year and L = thousands of optometrists.

a. Find the equilibrium wage and employment levels.

b. Now suppose that the demand for optometrists increases and the new demand

curve is L'd = 66 - W. Assume that this market is subject to cobwebs because it

takes about three years to produce people who specialize in optometry. While this

adjustment is taking place, the short-run supply of optometrists is fixed. Calculate

the wage and employment levels in each of the first three rounds and find the new

long-run equilibrium. Draw a graph to show these events.

Answer: a. Initial equilibrium W = $35, W = 15. (Find this by setting Ls = -6 + .6W = Ld

= 50 - W and solving for W.)

b. First round: L is still 15, so W = $51. This is point A in the figure. (Find W by

plugging L = 15 into the new Ld equation.)

56

Second round: Labor supply reacts to first round wage, L = 24.6, but this pushes W down

to $41.4 (at point C). Find this by plugging W = $51 into the Ls equation to find L = 24.6,

and then plugging L = 24.6 into the new Ld equation.

Third round: Labor supply reacts to second round W, L = 18.84, but this pushes W up to

$47.16 (see point E). Find this by plugging W = $41.4 into the Ls equation to find L =

18.84 and then plugging L = 18.84 into the new Ld equation.

Long-run equilibrium, W = $45, L = 21. (Find this by setting Ls = -6 + .6W = Ld = 66 - W

and solving for W.)

Suggested Essay Questions

1. Assume that a developing country with a labor force that includes many children,

ages 10-14, wants to reduce the use of child labor. Suppose that it decides to open

more schools, so that children who do not now have a school near their home can

attend a school without a long commute. Analyze how opening new schools will

affect child labor, explaining these effects fully.

Answer. Human capital theory suggests that those making decisions about investing in

schooling weigh the present value of expected future benefits against the near-term cost.

One element of cost is forgone earnings, which will be nonzero for children who could

work. A second element, however, is the cost of commuting (time and expense, perhaps

involving living away from home) to school. Making schools more geographically

accessible, then, lowers the cost of investing in human capital – and theory predicts that

more young students would attend school rather than work.

2. A study shows that, for American high school dropouts, obtaining a General

Equivalency Degree (GED) by part-time study after high school has very little payoff.

It also shows, however, that for immigrants who did not complete high school in their

native countries, obtaining a GED has a relatively large payoff. Can signaling theory

be used to explain these results?

Answer. Graduating from high school is more or less the expectation for American

students, and those who drop out may be viewed as having a low aptitude (or low

tolerance) for learning, even if they later obtain a GED. Immigrants may come from

countries in which high schools are either more demanding or less available, so dropping

out may not send the same signal of low aptitude or tolerance. If, though a GED, these

immigrants are certified as knowing the equivalent of American high school graduates,

employers may prefer them to American GED recipients, other things equal.

57

CHAPTER 10 - WORKER MOBILITY: MIGRATION,

IMMIGRATION, AND TURNOVER

This chapter employs the human capital framework to analyze the phenomena of

geographic mobility and worker turnover. It demonstrates how the insights of human

capital theory can explain the observed patterns of mobility and turnover, including the

personal characteristics of those most likely to exhibit either kind of mobility.

The chapter also describes and analyzes immigration policy in the United States. It

considers the problem of illegal immigration and uses economic theory to identify the

gainers and losers from a more restrictive immigration policy. Finally, the section on

immigration concludes with an analysis of the overall effects of immigration (including

illegal immigration) on the "native" population.

The lengthy section on U.S. immigration policy is, of course, motivated by our human

capital analysis of individual migration. However, the section does not directly employ

human capital analytics. Thus, instructors who want their students exposed to human

capital analysis as it applies to geographical mobility and turnover, and who are willing

to forgo an analysis of the very topical issue of illegal immigration and what to do about

it, could save some time in the course by eliminating the section of the chapter on

immigration policy.

List of Major Concepts

1. Worker mobility can be viewed as a human capital investment, in which the benefit is

added utility in the future and the costs are the direct and psychic costs of quitting one

employer and seeking work elsewhere.

2. People will move from jobs or areas where pay is relatively low to jobs or areas

where pay is relatively high unless such mobility is inhibited by a short time horizon

(or high discount rate), costs of finding out about alternatives elsewhere, or high costs

of the move itself.

3. There is an element of self-selection in immigration because those who are most

likely to migrate are those for whom the net benefits of migration are largest

(although the benefits are often initially depressed by unfamiliarity with the language

or customs of the area to which they have moved).

4. Countries in which the earnings distributions is more compressed than in the United

States will tend to send relatively skilled workers to the United States, while those

with distributions that exhibit greater variance will tend to send less-skilled workers

to the United States. U.S. immigration has tended to become less-skilled in recent

years.

5. Like other investments, migration investments can fail to work out as expected,

resulting in "return migration."

58

6. A large influx of immigrants will tend to lower wages in the relevant labor markets

and create more employment, but only in special circumstances would an influx of X

immigrants take X jobs away from "natives."

7. The argument that immigrants fill jobs no "native" would take overlooks the fact that

inducements to work in a particular occupation are not independent of the wage being

offered.

8. Immigration may increase product demand and the demand for other skill grades of

labor.

9. If immigrants receive wages equal to their marginal product, the native population as

a whole will not experience a loss of income unless the immigrants receive

government services whose value exceeds the taxes they pay.

10. "Matches" between employer and employee are improved through the process of

voluntary quits and involuntary layoffs. The human capital model can be used to

model quit behavior.

11. Human capital theory can shed light on the cyclical pattern of quit rates, the pattern of

quit rates across age groups, and international differences in quit rates.

12. The costs of quitting and searching for a new job may produce an upward sloping

supply curve to individual firms, leading to monopsonistic behavior.

Answers to Even-Numbered Review Questions

2. One way for the government to facilitate economic growth is for it to pay workers in

depressed areas to move to regions where jobs are more plentiful. What would be the

labor market effects of such a policy?

Answer. Clearly, interregional migration would be increased as a response to this

migration subsidy, and employment would grow in areas of high economic opportunity.

The effects on employment in areas of reduced economic opportunity and the effects on

wages in both areas depend on assumptions made about the labor market.

If it is assumed that the labor markets in both areas are in equilibrium and that wages in

the area of reduced economic opportunities are lower than they are elsewhere, then there

would be incentives for workers to leave the low wage area and migrate to the higher

wage area. If there are high costs of migration, some workers would not respond to a

moderately large wage differential because the increase in wages would not be sufficient

to cover the cost of migration. However, when the costs of migration are reduced by the

subsidy, more people will respond to a given wage differential and move from the

depressed area to the area of better opportunity. This move will shift the supply curve for

59

the depressed area to the left, shift the supply curve for the area of better opportunities to

the right, and thus reduce the wage differential between the two areas.

If the problem in the sending area is one of unemployment due to wage inflexibility in

that area (that is, the wage rate lies above the equilibrium wage), then an increase in out-

migration will reduce unemployment in the sending area, although it may not affect the

wage rate.

4. Suppose the United States increases the penalties for illegal immigration to include

long jail sentences for illegal workers. Analyze the effects of this increased penalty on

the wages and employment levels of all affected groups of workers.

Answer. Jail sentences for illegal immigrants would reduce the net gains from

immigration, even if the probability of being apprehended is small. The reduced net

benefits from migration should reduce the number of illegal immigrants coming into the

country and, assuming these immigrants are unskilled workers, this reduction should

raise wages in the unskilled labor market. Thus, unskilled native workers benefit by the

imposition of jail sentences on illegal immigrants who are apprehended. Employment in

the unskilled market goes down, although unskilled employment among natives increases.

Skilled workers may be adversely affected by this new policy because reduced

immigration may mean reduced product demand (and therefore have a scale effect on the

demand for their services). Moreover, if skilled and unskilled workers are gross

complements, the reduction of unskilled employment and the increase in the unskilled

wage may cause the demand for skilled workers to decline. If there is a leftward shift in

the demand for skilled workers, there will be a reduction in wages and employment in the

skilled markets. (Of course, if skilled and unskilled workers are gross substitutes, the

decline in demand brought about by the reduction in product demand would be mitigated

or even offset by the increased substitution of skilled workers for the now-more-

expensive unskilled labor.)

Workers from outside the United States who would otherwise have become illegal

immigrants (but who are now deterred from immigration) will be worse off. However,

those who decide to immigrate and are not apprehended will be better off because they

will receive higher wages in the unskilled market.

6. The last two decades in the United States have been characterized by a very wide gap

between the wages of those with more education and those with less. Suppose that

workers eventually adjust to this gap by investing more in education, with the result

that the wages of less-skilled workers rise faster than those of the more-skilled (so

that the wage gap between the two falls). How would a decline in the wage gap

between the skilled and the unskilled affect immigration to the United States?

Answer. Immigrants at least implicitly compare the wages they can expect in the United

States with those they can expect in their place of origin. Thus, if the American unskilled

60

wage rises relative to the skilled wage, the United States should experience a rise in

unskilled relative to skilled immigration.

Further, because this declining gap between the educated and the less-educated serves to

make the American distribution of earnings more equal. Skilled workers tend to come

from countries with more equal earnings distributions than found in the United States

(many European countries, for example), while unskilled workers tend to come from

countries (often developing countries) with less equal earnings distributions. When the

American earnings distribution becomes more equal, there will be reduced incentives for

skilled immigration from Europe, say, and more incentives for unskilled immigration

from countries with less-equal distributions.

Answers to Even-Numbered Problems

2. Suppose that the demand for "rough laborers" is Ld = 100 – 10W, where W = wage in

dollars per hour and L = number of workers. If immigration increases the number of

rough laborers hired from 50 to 60, by how much will the short run profits of

employers in this market change?

Answer: The short-run profits of the employer equal the area below the MPRL curve and

above the wage rate. See the figure. This will increase from area W1AB in the figure to

area W2AC. Find the wage rates by plugging the employment levels into the Ld equation.

50 = 100 – 10W initially, so W = $5 per hour. 60 = 100 – 10W after the immigration, so

W = $4 per hour. The area of the triangle is .5(base x height), so the area of W1AB is

50x$5x.5 = $125 per hour, and the area of W2AC is 60x$6x.5 = $180 per hour. Thus,

profits have risen by $55 per hour.

61

Suggested Essay Questions

1. Two oil-rich middle-east countries compete with each other for the services of

immigrants from India and Pakistan, who perform menial jobs that local workers are

unwilling to perform. Country A does not allow women to work, drive or go out of

the house without a chaperone. Country B has no such restrictions. Would you

expect the wages these two countries pay for otherwise-comparable male immigrants

to be roughly equal? Why or why not? Explain.

Answer. The supply of immigrants to A will be restricted, partly because female

immigrants who want to work will not go there and partly because married men will

avoid A because of the restrictions on their wives. The wages in A will have to be higher

in order to attract immigrants.

2. A particular manufacturing company employs low-skilled workers in a developing

country in which turnover among such workers is generally high. The company’s

president states that it is her goal to ensure that “workers have a serious emotional

connection to our company.” The company is unusual in that it offers air

conditioning, showers, tuition for English courses, and monthly parties. In what ways

might these policies make it difficult to retain employees, and in what ways might

they help?

Answer. The provision of these non-wage benefits is costly, and the theory of

compensating differentials suggests that their presence will serve to reduce the wages that

their workers could otherwise command elsewhere. Lower wages, by themselves, will

tend to increase turnover at the firm, especially among workers who do not value the non-

wage benefits very highly. However, these benefits will also serve to attract those who

value the amenities of parties, education in English, air conditioning, and so forth – and

because these amenities are unusual, those who place a high value on them will tend to

remain with the firm (the could not get them elsewhere).

62

CHAPTER 11 - PAY AND PRODUCTIVITY

This chapter explores in detail the relationship between compensation and productivity. It

begins with a discussion of the employment contract, which is largely implicit and

legally unenforceable. How this contract can be made self-enforcing within the context of

asymmetric information is the principal focus of this section.

After discussion of some general issues relevant to worker motivation, we turn (in

sequence) to an analysis of how motivation is affected by the basis of pay, the level of

pay, and the sequencing of pay. Thus, we discuss in turn issues related to piece rates,

commissions, profit sharing, and hourly pay (including merit pay); efficiency wages; and

deferred payment schemes, promotion tournaments and the issue of "career concerns. "

The chapter ends with a short section on two puzzles: why earnings increase with tenure

and why they increase with firm size.

List of Major Concepts

1. Productivity varies across workers and over time for a given worker, and it involves

taking the initiative in a myriad of hard-to-observe ways that advance the employer's

interests.

2. Contracts can be both formal and implicit, with the latter being incompletely

specified and hence legally unenforceable.

3. For an implicit contract to be self-enforcing, the parties can rely on signals that they

are contracting with the "right kind" of person; alternatively, they can structure the

contract so that the other party derives more from honest continuation of the

employment relationship than from reneging on their promises.

4. Dividing a "surplus" between marginal revenue product and the alternative wage is

critical to a self-enforcing employment contract; this surplus can be created by labor

investments of one sort or other.

5. Workers can be motivated to be highly productive by close supervision or by having

their earnings tied to their performance; the latter method requires that the measures

of their performance be correlated with their effort and the employer's objectives.

6. Because of group considerations, motivation techniques must take account of the

perceptions of fairness and issues of group loyalty.

7. Compensation schemes are jointly chosen by employer and employee.

8. Schemes that tie pay to individual productivity must take account of worker risk

aversion, but they are useful in eliciting signals about worker characteristics.

63

9. Output is not normally one-dimensional, and if pay is based on objectively-measured

aspects of output ("quantity"), workers will put forth little effort to increase output

along the other (subjective, or "quality") dimensions.

10. Group incentive schemes run the risk of creating "free rider" problems.

11. Time-based pay with merit increases can be based on either absolute or relative

output; absolute measures do not correlate as closely with individual effort, but

relative measures can induce counterproductive behaviors among employees.

12. Employees who feel generously treated by their employers may put forth greater

effort; hence, by increasing their wages employers can increase the productivity of

their workers (the efficiency wage).

13. Efficiency wages are most effective when the employer-employee tenure is expected

to be long.

14. With long expected tenures, the sequencing of pay is also an option; this option

promises handsome future rewards for current effort.

15. One scheme involves a period of underpayment followed by later overpayment,

which has both signaling value in obtaining future-oriented, hard-working employees

and offers incentives for current workers to put forth effort.

16. Promotion tournaments also have signaling and incentive value.

17. Employee "career concerns" (which can involve future payoffs with other employers)

can both distort and enhance efforts with one's current employer.

18. Concepts in this chapter contribute to the cluster of hypotheses that seek to explain

why wages rise with tenure and why large firms pay higher wages.

19. As firms increase in size it becomes increasingly costly to monitor worker effort, and

one way to cope with this monitoring problem is to pay higher wages. The higher

labor costs associated with greater firm size suggests that the labor supply curve to a

firm may be upward sloping, and this may explain monopsonistic behavior among

firms in the labor market.

Answers to Even-Numbered Review Questions

2. The earnings of piece-rate workers usually exceed those of hourly paid workers

performing the same tasks. Theory suggests three reasons why. What are they?

Answer. First, if stability of hourly pay is preferred to the potential fluctuations of piece

rate pay, then part of the "earnings premiums" enjoyed by piece-rate workers is a

compensating wage differential. Second, piece-rate pay will appeal most to workers of

64

above-average productivity; therefore, such workers are most likely to accept jobs paid

by the piece. Third, piece rates increase the incentives of given individuals to expend

effort, which increases their pay.

4. Suppose two soft-drink bottling companies employ drivers whose job it is to deliver

cases of drinks to stores, restaurants and businesses. One company pays its drivers an

hourly wage, and the other pays them by the number of cases delivered each day

(which can be affected by efforts of drivers to visit and sell to new customers). Which

company is more likely to experience higher rates of traffic accidents among it

drivers? Why?

Answer. Drivers paid by the piece are motivated to deliver more cases per day. They will

probably drive faster so they can make more calls, and they therefore might have a higher

accident rate.

6. Some real estate brokers split the commission revenues generated by each sale with

the responsible agent. Others, however, require their agents to pay them (the brokers)

money up-front, and then allow the agents to keep the entire commission from each

sale they make. Which agents would you predict to have the larger volume of sales,

those who split all commissions with their employer or those who pay an up-front fee

to their employer and then keep the entire commission? Explain.

Answer. There are two reasons to expect that agents paying an up-front fee will generate

more sales. First, having paid the fee, agents can keep the entire commission from each

additional sale. Their incentives to make an additional sale are therefore stronger, and

one would expect them to work longer hours and engage in more intensive efforts to

increase their sales volume. Second, the requirement to pay the broker an "employment

fee" in advance of sales will restrict interest in that kind of pay scheme to those agents

whose experience and skills give them reasonable assurance they will have a high sales

volume. Thus, the "up-front fee" scheme calls forth signals about the agents' own

expectations concerning volume (in this regard it has effects analogous to those of the

"underpayment-then-overpayment" compensation scheme described in the text).

8. An amusement park open only in the summer hires teenagers to operate its rides and

concession stands, paying them $4.00 per hour and putting aside $1.50 per hour into a

fund that they will receive as a lump-sum payment if they work through Labor Day

(typically, its biggest day of the year).

(a) What problem is the amusement park apparently trying to solve with its

compensation plan, and in what two ways does this plan help to solve the problem?

(b) Suppose the government rules that the compensation plan violates minimum

wage laws because workers who quit before Labor Day receive only $4.00 per hour.

How can the park now address the problem mentioned in your answer to (a)?

Answer. (a) The park has apparently had trouble keeping its teenage workforce through

Labor Day. This compensation plan will appeal most to job applicants who intend to

65

work through Labor Day (that is, it has signaling value), and it also gives current workers

incentives to stay on through then.

(b) If the plan is struck down, the park has limited alternatives owing to the seasonality of

its labor demand (which probably rules out efficiency wages and other plans based on

long-term attachments). It could invest more in screening applicants, substitute capital for

labor, or devote more resources to supervising employees (with an eye toward persuading

them to stay on the job or capitalizing on "career concerns" by providing detailed

recommendations to future employers).

Answers to Even-Numbered Problems

2. A firm is considering the adoption of a plan in which it would pay employees less

than their MRPL early in their careers and more than their MRPL late in their careers.

For a typical worker at the firm MRPL = 10 + .1T, where T = the number of years

which the worker has been employed at the firm and MRPL is measured in dollars per

hour. The worker's wage per hour is W = 8 + .2T. Assume that this wage is high

enough to attract workers from alternative jobs, that the discount rate for the firm is 0,

and that the expected tenure of a typical worker is 35 years. If workers retire after 35

years, will this plan be profitable for the firm? Explain. For how many years will the

firm "underpay" it workers?

Answer: The graph shows the wage and MRPL lines, which cross after 20 years. The

firm will adopt the plan because it expects to profit from it -- the early underpayments

exceed the later overpayments. (Because the discount rate is zero, we can find the

present value of underpayments and overpayments by simply adding them up.) Triangle

A (the initial underpayment) and triangle B (the later overpayment) are equal when T =

40 years. Triangle A exceeds triangle B if retirement comes before tenure equals 40

years.

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Suggested Essay Questions

1. Firm X is working with Firm Y on creating innovative educational materials that will

be used to create courses to be taught using the internet. Firm X is supplying the

computer specialists, while Firm Y is supplying the course content materials. Both

firms will share in the profits of the courses they jointly produce. Firm X wants Firm

Y to adopt financial incentives for its employees working on this project to finish

their work according to a deadline. Under what conditions will incentives be most

effective? Are these conditions likely to hold in this case?

Answer. Production incentives are most effective when they perfectly align the interests

of workers and owners, and when a worker’s output is only affected by his or her effort

(and not affected by factors outside the control of the individual). In this case, we must

question whether either condition is met. First, producing a high-quality course in a

brand new environment requires creativity in dealing with issues that cannot be foreseen,

so tailoring incentives to deadlines might not align the interests of employer (who wants

quality) and employee (who wants to meet a deadline). Second, X and Y are jointly

producing these programs, so delays or mistakes made by one team will affect the ability

of the other to meet the deadline; put differently, the output of Y is not completely under

the control of its workers.

2. A recent magazine article on Japan’s economic problems stated that, “As the post-war

baby-boomers reach their 50s, Japan’s lifetime-employers are carrying the cost of

67

paying their senior workers more than they are worth.” Is this comment consistent

with economic theory? Explain.

Answer. Yes, it is consistent. Employers offering lifetime jobs have the ability, and

often the incentive, to offer a payment scheme that underpays workers in their early years

(wage less than marginal product) and overpays them later on (wages greater than current

marginal productivity). The later overpayment serves to compensate workers for their

earlier underpayment, and it is necessary to attract workers to the firm. The purpose of

this scheme is to provide incentives for employers to stay with the firm and work

diligently (and honestly), lest they be discovered shirking and lose the opportunity for

overpayment.

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CHAPTER 12 - GENDER, RACE, AND ETHNICITY IN THE

LABOR MARKET

This chapter represents a comprehensive inquiry into wage differentials across gender,

racial and ethnic groups. It begins with a section on earnings differences by gender, in

which the overall differential is broken into two parts: that associated with measurable

productivity differences and that associated with unobserved (unexplained) differences.

The latter differences are associated with (but not confined to) current market

discrimination. Discrimination is defined and problems of its measurement are discussed

in the context of analyzing gender differences in earnings.

Black-white earnings differentials are analyzed next in a subsection that includes a brief

treatment of differences in the ratios of employment to population. Earnings by ethnicity

are also discussed. In each case, the analysis includes a review of attempts to estimate the

effects of discrimination, with special emphasis on the effects of such hard-to-observe

factors as English language proficiency, cognitive achievement, and school quality.

The second major section of the chapter analyzes theories of market discrimination.

Becker's theories of employer, customer, and employee discrimination are discussed, and

the theory of statistical discrimination is explained, along with noncompetitive models of

discrimination (occupational crowding, dual labor markets, search-based monopsony,

and theories involving collusive action).

The chapter concludes with in-depth discussions of governmental efforts to reduce or

eliminate market discrimination: the Equal Pay Act of 1963 and the Civil Rights Act of

1964. Included in our discussion of the last are the evolution of the disparate impact

standard by the courts (as opposed to a disparate treatment standard), legal decisions

involving seniority, and the emerging comparable worth remedy. The chapter closes with

an analysis of the federal contract compliance program, including the standards against

which affirmative action plans are judged and the results of studies that have tried to

assess the effects of the program.

The appendix to Chapter 12 contains an introduction to the problems of estimating

comparable worth "earnings gaps." The purpose of this appendix is twofold: to give

students a brief illustration of the use of regression analysis and to show them how

comparable worth comparisons are made.

List of Major Concepts

1. Income disparities between men and women may have their roots in different

incentives to acquire productive characteristics.

2. Current labor market discrimination is said to exist when the market places values on

personal characteristics of workers that are unrelated to productivity.

69

3. Earnings differentials caused by differences in productive characteristics are termed

"premarket."

4. Occupational segregation is one form of discrimination, and it can be measured by an

index of occupational dissimilarity; however, it is difficult to distinguish between the

effects of occupational choice and those of employer discrimination.

5. To measure the extent of wage discrimination, one must determine what the earnings

ratio would be if the protected class and white males had the same productive

characteristics. However, the adjusted differential is in reality an unexplained

differential, and it could reflect the effects of unmeasured worker characteristics as

well as market discrimination.

6. Much of what appears to be labor market discrimination against women takes the

form of occupational segregation, which, while still rather marked, seems to be

declining somewhat recently.

7. When productive characteristics are controlled in an analysis of earnings differentials,

they account for all but roughly 10 percentage points of the gender wage differential.

8. Differences in the black-white employment-to-population ratio are a function of both

higher unemployment rates and lower labor force participation rates among blacks.

9. Studies using convention ally-measured variables for productive characteristics

suggest that about 11 percentage points of the observed disparity between black and

white males may be due to current labor market discrimination. Studies that control

for cognitive achievement scores as well suggest that black men earn from 8 percent

more to 8 percent less than white men with comparable productive characteristics.

10. Human capital and language-proficiency differences account for A but 3 to 7

percentage points of the Hispanic wage differential.

11. If employers discriminate against some group of workers, they will act as if they

believe the marginal product of those workers is lower than it really is. Thus, they

will hire fewer such workers than would be called for by profit maximization, and

those who are the most discriminatory will make the least profits.

12. Under employer discrimination, the behavior of prejudiced employers will reduce

demand for the minority group and cause a wage differential to exist. The size of the

differential depends on the size of the minority population relative to the distribution

of prejudiced employers in the market.

13. The implication that prejudiced employers will be less profitable suggests that

discrimination ought to be eliminated over time as nonprejudiced (profitable)

employers buy out less profitable, prejudiced employers.

70

14. Like employer discrimination, customer discrimination implies a shift to the left of

the demand curve for the services of a protected class. However, with customer

discrimination, a reduction in productivity is, from the employer's perspective,

genuine.

15. Employee discrimination generates supply-related behavior that might cause

employers to segregate their plants by race or sex if possible. If not, wage

differentials will arise as a result of the need of employers to retain workers in the

prejudiced group.

16. Statistical discrimination arises from a screening problem in which job applicants are

evaluated both on their individual characteristics and on average characteristics of the

group to which they belong. Statistical discrimination should be reduced in situations

in which the variance of individual characteristics around the group average widens.

17. Both the crowding hypothesis and theories emphasizing the dual labor market suggest

the presence of noncompeting groups, but they do not satisfactorily explain the

creation of these groups.

18. If search costs create upward-sloping labor supply curves to individual employers,

and if discrimination raises the search costs of certain groups of workers, then

monopsonistic behavior will create wage differentials among otherwise identical

workers.

19. Some theorists use collusive action on the part of employers to explain the creation

and persistence of noncompeting groups. Employers are seen as deliberately dividing

the labor force to guard against cohesive collective action by workers, but the theory

does not explain how an employer cartel is maintained in the face of clear-cut

incentives to cheat.

20. Anti-discrimination programs by the government must set standards for both

employment and wages. If employment standards are the only ones used, prejudiced

employers may comply by paying protected-class workers less than white males. If a

wage standard is the only one applicable, then prejudiced employers will respond to

increased wages for protected classes by reducing employment.

21. A disparate treatment standard imposed under the Civil Rights Act judges that

discrimination has occurred if different procedures are used for different groups of

people and if it can be shown that there was an intent to discriminate. Proving intent

is difficult, and policies that may appear to be neutral on the surface may nevertheless

perpetuate the effects of past discrimination.

22. Courts have moved towards a disparate impact standard, by which it is labor market

results, not motivation, that counts. Under this standard, policies that lead to different

effects by race and sex are prohibited unless a business "necessity" can justify their

use.

71

23. Because of occupational segregation, men and women often occupy dissimilar jobs.

The comparable worth remedy is based on comparing the skill content, responsibility,

and working conditions in jobs for purposes of pay comparisons; however, mandating

wage increases for women could reduce the incentives of employers to hire them.

24. The Federal Contract Compliance Program seeks to shift the demand curve for

protected classes to the right. Federal contractors are required to file affirmative

action plans that state their goals for hiring and promoting members of protected

classes (taking account of "availability").

25. Realistic estimates of availability should account for the compensation policy of the

firm, the willingness of workers to commute to the firm, the degree to which the firm

has incentives to train new employees, and the extent to which job applicants can be

induced to move to the firm's labor market area.

26, Studies to evaluate the effects of government anti-discrimination efforts have focused

on time series analyses of earnings ratios and effects on federal contractors

(emphasizing changes in employment levels, wages, and quit rates for protected-class

workers).

27. (Appendix) Estimating comparable worth earnings gaps typically involves evaluating

characteristics of jobs for men and women and estimating the relationship between

these characteristics and compensation for white males. This relationship can then be

used to estimate what women would receive if they were paid on a basis comparable

to men.

28. (Appendix) A precise and informative way of estimating the relationship between

point scores and compensation would be to use ordinary least squares regression

techniques to fit the "best" line through the observed points on the graph. The

estimated coefficient on the point score variable is an estimate of how much a unit

change in that variable affects earnings.

Answers to Even-Numbered Review Questions

2. “In recent years, the wage gap between skilled and unskilled workers in the United

States has grown. This growth means that measured labor market discrimination

against unskilled Mexican immigrants is also growing.” Comment on whether the

second part of this statement is implied by the first part.

Answer. Labor market discrimination is said to exist when workers who are productively

equivalent are systematically paid different wages based on their race or ethnicity (or

some other demographic characteristic unrelated to productivity). It is true that rising

inequality causes a greater gap between the average wages of native whites and unskilled

Mexican immigrants, because native whites are better educated and more skilled, on

average. However, the existence (and size) of labor market discrimination depends on

the wage gap between unskilled native whites and unskilled Mexican immigrants (that is,

72

between two productively equivalent groups) – so the facts quoted in the statement are

not sufficient to determine if labor market discrimination is growing.

4. Assume there is a predominantly black, central-city school district surrounded by

white, suburban districts that recruit teachers from the same pool. Black teachers are

equally willing to teach in both places, but white teachers are reluctant to take jobs in

the central city (assume their prejudice extends only to students, not to black teachers).

Assume further that there are not enough black teachers to fully staff the central city

schools. If the law requires teachers in the same district to paid equally, but allows

salaries across districts to vary, will black teachers earn more, the same, or less than

white teachers? Why?

Answer. Because there are too few black teachers to completely staff central city schools,

these schools must attract white teachers who, by hypothesis, prefer to teach in suburban

schools. Thus, to attract enough white teachers to fill the job slots, the central city schools

must raise wages (this wage increment would act as a compensating wage differential,

compensating white teachers for taking jobs they might otherwise find "distasteful").

Because salaries for all teachers within a school district must be equal, the black teachers

in the central city schools must receive the higher wages there, also.

Wages in the suburban schools will be lower than the wages in central city schools,

because these schools can attract the white teachers without offering a compensating

wage differential. Because black teachers, by hypothesis, are equally willing to work in

central city or suburban schools when wages are equal, suburban schools will not be able

to attract black teachers (who will find the higher wage at the central city schools more

attractive).

6. You are involved in an investigation of charges that a large university in a small town

is discriminating against female employees. You find that the salaries for professors

in the nearly all-female School of Social Work are 20 percent below average salaries

paid to those of comparable rank elsewhere in the university. Is this university

exhibiting behavior associated with employer discrimination?

Answer. There are different relative demands and supplies by academic field that are

reflected in differential salaries. Professors of social work, therefore, may receive

relatively low wages because the supply of labor to that field is greater relative to demand.

Whatever the cause of the large relative supply of women to the social work field, it is

not obvious that this particular university is engaged in the behavior we could attribute to

employer discrimination.

Employer discrimination can be observed in two instances. One occurs when, with equal

wages for men and women, the employer clearly prefers to hire men over women of

comparable productive characteristics. The other occurs when, given a lower market

wage for women relative to comparable men, the employer fails to hire an all-female

work force. Because the university has apparently hired a nearly all-female work force in

the School of Social Work, it does not seem to exhibit this latter behavior.

73

8. In the 1920s South Africa passed laws that effectively prohibited black Africans from

working in jobs that required high degrees of skill; skilled jobs were reserved for

whites. Analyze the consequences of this law for black and white South African

workers.

Answer. The effects of the law on black Africans were unambiguously adverse. Blacks

were crowded into low-paying unskilled occupations, for which the wage was driven

down still further by the requirement that blacks could not do other work. Those who

would have chosen to obtain training for skilled positions were not able to do so.

The effects of the laws on white workers were ambiguous. Skilled white workers were

helped, in the sense that they received higher wages than they would have received

otherwise (had blacks been allowed into the skilled trades). Unskilled whites, however,

were probably made worse-off by this law because of its effects on the unskilled wage.

Some unskilled whites, however, reacting to the increased wage differential between

skilled and unskilled jobs, would have elected to obtain the training necessary for

entrance to a skilled trade.

Answers to Even-Numbered Problems

2. Suppose that MRPL = 20 - .5L for left-handed workers, where L = the number of left-

handed workers and MRPL is measured in dollars per hour. The going wage for left-

handed workers is $10 per hour, but employer A discriminates against these workers

and has a discrimination coefficient, D, of $2 per hour. Graph the MRPL curve and

show how many left-handed workers employer A hires. How much profit has

employer A lost by discriminating?

Answer: See the figure. A non-discriminating employer will hire left-handers until

wage = MRPL. Because 10 = 20 - .5L when profits are maximized, then L = 20 workers

for a profit-maximizing employer. Employer A, however, will hire left-handers until

wage + D = MRPL. Since 10 + 2 = 20 - .5L, then L = 16 for employer A. Lost profits

equal triangle ABC, whose area is 4 x $2 x .5 = $4 per hour.

74

4. (Appendix) In the market for delivery truck drivers, Ls = -45 + 5W and Ld = 180 –

10W, where L = number of workers and W = wage in dollars per hour. In the market

for librarians, Ls = -15 + 5W and Ld = 180 – 10W. Find the equilibrium wage and

employment level in each occupation and explain what will happen if a comparable

worth law mandates that the librarian wage be increased to equal the delivery truck

driver wage. Use a graph.

Answer: To find the equilibrium wage for truck drivers, set Ld = Ls and solve for W:

-45 + 5W = 180 – 10W, or 15W = 225, so W = $15 per hour

Plugging this into the two equations shows that, for truck drivers, L = 30. The calculation

for librarians is as follows:

-15 + 5W = 180 – 10W, or 15W = 195, so W = $13 per hour

For librarians, L = 60. If the librarians' wage were increased to $15 per hour, employers

would move back along the Ld curve from point A to point B on the figure below and hire

fewer librarians, reducing their employment from 60 to 40.

75

Suggested Essay Questions

1. Will government-mandated requirements to hire qualified minorities (at non-

discriminatory wages) in the same proportions they are found in the relevant labor

force reduce the profits of firms that formerly engaged in employer discrimination?

Fully explain your answer.

Answer. Firms that engage in employer discrimination forgo profits in order to indulge

their prejudices. Thus, requiring them to hire and pay qualified minorities in proportion

to their availability will not reduce profits. (It will, however, reduce the utility owners

derive from their businesses.)

2. Will government-mandated requirements to hire qualified minorities (at non-

discriminatory wages) in the same proportions they are found in the relevant labor

force reduce the profits of firms that formerly faced customer discrimination? Fully

explain your answer.

Answer. If customers are prejudiced, they will tend to avoid businesses hiring workers

from groups they are prejudiced against; thus, profit-maximizing employers will prefer to

hire workers from groups that customers do not have distaste for. If the law requires

employers to hire from all groups proportionately, firms previously attracting prejudiced

customers will lose business (either to firms that might not be covered by the law, or

when consumers substitute other goods or services for the one in question); however,

their costs could go down now that there is no reason for paying a premium to workers

76

from “favored” groups. Firms previously attracting non-prejudicial customers will now

be unable to capitalize on the lower demand (and lower wages) for minority workers, so

their costs will rise.

77

CHAPTER 13 - UNIONS AND THE LABOR MARKET

The major focus of this chapter is on the economic effects of unions, in both the private

and public sectors. It begins with some necessary definitions and descriptions of

unionism in the United States compared to elsewhere in the world, before turning to

elementary coverage of major pieces of labor legislation in the United States.

In seeking their objectives, unions are constrained by the demand for their members'

services. Unions facing relatively inelastic demand curves are better able to raise wages

without adversely affecting employment levels very much. The simplest model of unions'

objectives is the "monopoly union" model, in which the union sets the wage and the

employer adjusts by setting the employment level. A more complex model is the

"efficient contracts" model, in which the union and firm jointly bargain over wage and

employment levels.

In attempting to explain the major activities of unions, we have organized the analysis

around the demand for unions by workers and the supply of union services by labor

unions. We use this analysis to help understand the major trends in American

unionization. No discussion of union behavior would be complete without an analysis of

strike activity and (for the public sector) interest arbitration. The section on strikes

include an exposition of the Hicks model of bargaining and the Ashenfelter-Johnson

political model of strike behavior (including the effects of the Landrum-Griffin Act). The

section on arbitration discusses the contract zone in the context of both conventional and

final-offer arbitration.

Having analyzed some key characteristics of union behavior, we turn to an analysis of the

effects of unions on wages and other workplace outcomes. The measurable effect of

unions on wages is the relative wage advantage, found by comparing union wages to

wages in the nonunion sector. The true (or absolute) effects of unions on wages are not

measurable, and the possible biases inherent in measuring the absolute effects using

relative-effect measures are discussed at length. We close the chapter by summarizing

empirical evidence on the effects of unions on relative wages, total compensation,

employment, productivity, and profit, and discuss both "traditional" and alternative views

of union effects on the overall social welfare.

The appendix to Chapter 13 analyzes how the uncertainty of arbitrators' decisions affects

bargaining outcomes. As in the appendix to Chapter 8, the discussion defines and

illustrates the concept of risk aversion..

List of Major Concepts

1. Union membership as a fraction of the population in the United States is low relative

to the other major industrial countries, and American union activities are relatively

decentralized.

2. Unions are constrained in their objectives by the labor demand curve.

78

3. The monopoly-union model assumes that the union sets the wage and the employer

sets the employment level.

4. The "efficient-contracts" model emphasizes that if unions and employers bargain only

over wages, the resulting employment/wage outcome will be inferior to another set of

outcomes that would improve the welfare of both parties. Under this model, the two

parties bargain over both wage and employment levels.

5. The decline in American union membership can be understood, in part, by reference

to shifts in the demand and supply curves for union services (caused by the

feminization of the work force, a change in industrial composition, regional shifts,

competitive pressures, and employer resistance).

6. Unions often take actions designed to shift the demand curve for labor to the right

and/or to reduce the elasticity of demand for union labor.

7. Strikes are intended to impose financial costs on employers if they do not agree to

union offers, but because they also impose costs on employees, both sides become

more willing to make concessions as strike duration increases. The Hicks bargaining

model suggests when strikes will end, but it does not explain why strikes occur in the

first place.

8. While strikes can occur because one party mistakes the other's true position, they can

also occur because, in the context of asymmetric information, one party wants to

elicit a signal from the other about its true preferences or constraints.

9. The Ashenfelter-Johnson model of strike activity, which is tripartite in nature, views

union leaders and union members as sometimes having conflicting perspectives.

Union leaders, who have better information than their members, may pursue the twin

goals of maintaining their positions in the union and educating union members by

recommending a strike.

10. Unions' propensities to strike vary over the business cycle and have trended down

over time, but the increase in union democracy associated with the Landrum-Griffin

Act caused a one-time increase in strike activity (as predicted by the Ashenfelter-

Johnson model).

11. Interest arbitration is used in the public sector, where strikes are generally not

permitted, and interest arbitration can be "conventional" or "final offer."

12. The "contract zone" into which pre-arbitration offers will fall can be widened by both

the uncertainty about what an arbitrator might decide and the parties' aversion to the

risk of an adverse outcome. However, it is not clear whether a wider contract zone

increases or reduces the chances a dispute will go to arbitration.

79

13. One would like to measure the effects of unions on wages in the absolute (comparing

wages in a world with unions to wages in a world without); however, measuring this

absolute wage advantage is impossible. We can only measure union wages relative to

nonunion wages, but this is not a good measure of the absolute effect because the

presence of unions alters the nonunion wage also.

14. If the nonunion labor market is in equilibrium, the presence of unions should lower

the nonunion wage below what it would have been otherwise and cause the relative

wage effect to overstate the absolute effect of unions.

15. If employers raise wages in the nonunion sector to keep unions out (thus creating

unemployment in that sector), the relative wage effect is smaller than the absolute

union wage effect.

16. The presence of wait unemployment in the union sector will inhibit the growth in

labor supply in the nonunion sector and could even cause the supply curve there to

shift left. Whether wait unemployment causes the relative wage effect to be greater or

smaller than the absolute wage effect depends on whether the supply curve of labor to

the nonunion sector shifts to the right or left.

17. In an overall sense, unions appear to raise the wages of their members above the

nonunion wage by something like 10 to 20 percent. These wage effects are larger in

the private than the public sector, larger in the United States than elsewhere, and

largest among unskilled (and minority) workers.

18. Union effects on employee benefits as a percentage of total compensation tend to be

positive; thus, the total compensation effects of unions may be greater than the

relative wage effects.

19. The compensation advantages enjoyed by union members; however, may be in part a

compensating wage differential for the more structured, more hazardous and less

flexible work settings in unionized firms.

20. Empirical evidence tends to suggest that, in the United States, unionization reduces

employment or employment growth, has an ambiguous effect on productivity, and a

negative effect on profits.

21. The traditional view of union effects stresses the social loss caused by inequality in

wages (and marginal productivities) among workers of comparable skill. The

traditional view also stresses the losses associated with union staffing requirements,

restrictive work practices, and strikes.

22. The alternative view of unions is that they provide a method of collective "voice" that

tends to reduce turnover and encourage firms to provide specific training to

employees. Improved communications between labor and management may also

increase productivity and worker motivation directly, but employer resistance to

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unions and the degree to which stock market prices are depressed when union

organization drives are initiated suggest a widespread belief that unions reduce

profitability.

23. (Appendix) When collective bargaining impasses can be decided by arbitration, the

range of possible nonarbitrated settlements is widened by greater uncertainty about

how the arbitrator will decide (if an agreement is not reached) and by greater risk

aversion on the part of the parties.

Answers to Even-Numbered Review Questions

2. Some collective bargaining agreements contain "union standards" clauses that

prohibit the employer from farming out work normally done in the plant to other

firms that pay less than the union wage.

a. What is the union's rationale for seeking a union standards clause?

b. Under what conditions will a union standards clause most likely be sought by a

labor union?

Answer. (a) The union's goal for seeking the union standards clause is to remove

incentives for the employer to substitute cheaper nonunion labor for more expensive

union labor.

(b) The ultimate goal of the union, of course, is to raise wages while preserving

employment (or at least not having to undergo large employment declines). A union

standards clause will be more attractive to a union when the firm can more easily

substitute outside factors of production for those it employs and when these substitution

effects are large. Analogously, the union standards clause will be more successful in

preserving employment of union members if the firm finds it more difficult or expensive

to substitute capital for labor within the firm. Likewise, if the supply of capital to the firm

is relatively inelastic, any tendency to substitute capital for labor will be met with a rising

price of capital, which will mitigate the amount of capital/labor substitution that might

otherwise accompany a union standards clause. Moreover, a union standards clause will

be more successful in preserving employment, and therefore more sought-after, if the

product demand curve is relatively inelastic (so that scale effects are small).

4. It has been observed that unions in the capital-intensive steel industry were able to

negotiate higher-than-average wage increases during the very period in which steel

output in the United States was declining. Using economic theory, how can this

pattern be explained?

Answer. When output is contracting, one would think that the shrinking demand for

workers (owing to the scale effect) would reduce a union’s ability to negotiate wage

increases without harming job opportunities for its members. However, when output is

contracting, employers are not adding to their capital stock or opening new plants, so

technological improvements that substitute capital for labor are not easily made. The

81

reduced ability to substitute capital for labor serves to strengthen the union’s hand,

because even if wages rise the substitution of capital for labor may not take place.

6. In the mid 1980s the teachers' union of a large American city was given a choice: it

could accept a 10 percent cut in the salaries paid to teachers and suffer no employment

losses, or it could keep salaries constant and accept a 10 percent cut in employment

levels (and a corresponding ten percent increase in class sizes). Given that union

leaders are elected by the membership, please answer the following:

a. Predict and explain the union's decision, assuming that its collective bargaining

agreement with the city specifies that any layoffs will occur among those

teachers most recently hired.

b. Explain whether the decision in (a) would have been different if the collective

bargaining agreement had specified that all layoffs would occur on a random

basis, independent of seniority, teaching field, or any other teacher

characteristics.

Answer. (a) If layoffs occur only among the most recently hired, it is possible for each

union worker to calculate whether he or she is among the group to be laid off. Therefore,

90 percent of all union members will know that they will not be laid off, and 10 percent

know for sure that they will be. Because the union leaders who had to make this decision

are elected by majority rule, it is a safe bet that they would act in the interests of the

majority (who would not be laid off) and would therefore choose to maintain current

salaries and accept layoffs of 10 percent.

(b) If layoffs are to be made randomly, then each union member has a 10 percent chance

of being laid off if salaries are held constant. Alternatively, members could accept a 10

percent cut in their salaries with the assurance that they would not be laid off. In either

case, in advance of the decision that must be made by the union, each worker would face

a 10 percent decrease in expected wages. In this case, it is much more likely that the

union would choose to accept salary cuts than cuts in employment. A simple political

model of union decision making could not predict for sure that unions would accept

salary cuts in this case, although they probably would if their workers were risk averse.

However, compared to the case in which layoffs are made among those most recently

hired, the chances of the union's deciding to accept employment cuts are much lower.

8. Is the following statement true, false, or uncertain? “The empirical studies indicating

that unions raise the wages of their members by 10 to 20 percent relative to the wages

of comparable nonunion workers imply that unions have a negative effect on national

output.” Explain your answer.

Answer. The traditional view is that when workers of comparable potential are in jobs

with different productivities, society’s output could be increased if some moved from the

low- to the high-productivity jobs. However, if unions solve problems created by market

imperfections (workers can use “voice” rather than “exit,” for example), they may

enhance society’s total output.

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Answers to Even-Numbered Problems

2. The Brain Surgeon's Brotherhood faces an own-wage elasticity of demand for its

labor that equals -0.1. The Dog Catcher's International faces an own-wage elasticity

of demand for its labor that equals -3.0. Suppose that leaders in both unions push for

a 20 percent wage increase, but have no power to directly set employment levels.

Why might members of the Dog Catcher's International be more wary of the targeted

wage increase?

Answer: Own-wage elasticity of demand = %(quantity demanded)/%(wage). In the

case of the Dog Catchers this implies -3 = %(quantity demanded)/20%, thus

employment will fall by 60% if they boost wages by 20 percent. In the case of the Brain

Surgeons this implies -0.1 = %(quantity demanded)/20%, thus employment will fall by

only 2 percent if they boost wages by 20 percent.

Suggested Essay Questions

1. American unions often try to win public support for boycotting goods made in less

developed countries by workers who work very long hours at low pay in unhealthy

working conditions. (a) If successful, will these efforts unambiguously help the

targeted foreign workers? Explain fully. (b) Will they unambiguously help the

union’s American workers? Explain fully.

Answer. (a) If manufacturers in these less developed countries are induced to raise

wages and improve working conditions, output price will tend to rise and only those

consumers willing to pay the higher prices will remain in the market. Boycotting goods

made by workers in “sweatshop” conditions, then, tends to reduce demand (because of

both scale and substitution effects) for the services of low-wage labor, and these workers

may end up losing their manufacturing jobs and having to go back to farming or some

other job they previously felt was inferior, given their preferences and opportunities.

(b) If manufactured items from abroad become more expensive, we would expect that

consumers would tend to substitute American goods (now relatively cheaper) for foreign-

made goods. Thus, foreign and American workers may be considered substitutes in

production, and if this substitution effect is dominant, the will be gross substitutes. If so,

when the costs of foreign labor rise, the demand for American labor may rise. However,

we must also consider the scale effects associated with higher costs overseas. Some

American workers may have jobs (in packaging, selling, distributing) that depend on the

scale of output produced both in the U.S. and abroad. Clearly, the scale of output will

fall owing to the boycott, and the costs of producing the items in question will rise; some

workers, therefore, may be gross complements with foreign workers, and these workers

will be worse off if the boycott lasts and is successful.

2. A certain country has very centralized collective bargaining, under which wage

bargains are applied nationally. This country is thinking about adopting a bargaining

83

structure that is more decentralized, so that wage bargains will be made at the

individual plant or firm level. How would you expect decentralization to affect

wages and employment? Explain why.

Answer. Union power to raise wages is affected by the elasticity of demand for its

workers; where elasticity is higher, given wage increases will result in greater loss of

employment. A national union may perceive the product demand (and hence labor

demand) of employers to be relatively inelastic, because if it is able to raise wages in all

sectors, consumers have limited incentives for substituting goods from one sector for

goods from another. All employers will face higher wages and higher costs – and thus

have higher prices – although the degree to which their output prices will rise depends on

the share of labor in total cost and their ability to substitute for labor in the production

process. When bargaining is very decentralized, however, the unions involved in wage

setting will perceive the output demand elasticity to be relatively elastic, and they may

moderate their demands as a result. Thus, at a broad level of analysis, we might expect

wage increases to be larger, and employment losses to be larger, with centralized

bargaining.

At a more disaggregated level, however, we would expect that local unions facing labor

demand elasticities that are lower than the national aggregate to bargain for greater wage

increases than they got under centralized bargaining, while those with elasticities less

than the national aggregate would bargain for less. Thus, wage increases will be greater

than what they would have been under centralized bargaining in some sectors, and less in

other. Overall, a greater ability to tailor local demands to local elasticities should result

in a reduced level of job loss associated with unionization.

84

CHAPTER 14 - INEQUALITY IN EARNINGS

This chapter is intended to accomplish two purposes: to analyze changes in earnings

inequality after the 1980s and to review major concepts of economic theory introduced in

prior chapters. It begins with a section on measuring inequality and then moves to one

that describes changes in the 1980s and early 1990s along various dimensions: the

occupational distribution, relative wages, hours of work, and earnings dispersion within

narrowly-defined human capital groups.

The underlying causes of growing inequality are then grouped into supply factors,

institutional changes, and demand-side influences. Empirical studies are surveyed, with

the conclusion that demand factors were dominant in the 1980s (especially computer-

related technological changes that affected the mix of productive factors, leading to

increased relative demand for educated workers). The appendix discusses the derivation

of Lorenz curves and Gini-coefficients.

List of Major Concepts

1. Earnings inequality is a function of the dispersion of the earnings distribution, and

this dispersion can be measured in various ways, which differ in the ease with which

they can be completed and widely understood.

2. The most widely-used measures involve ranking the population and analyzing

earnings by percentile (comparing either shares of the total received by a group or the

earnings levels at percentile boundaries).

3. Earnings distributions for both men and women became "stretched" in the 1980s,

more because wages of those in the upper end grew relative to others' than to a

movement of jobs from the middle of the distribution to either end.

4. The most notable change in earnings for both men and women was the increase in the

relative earnings of more-educated workers; for men this increase occurred mainly

because earnings of the less-educated fell in real terms, while for women it was

associated mainly with the increased real earnings of more-educated women.

5. The returns to experience rose modestly, but only for the less-educated.

6. Changes in the relative hours of work played no role in the growth of inequality.

7. Earnings also became more dispersed within human-capital groups.

8. Growing disparities could result from labor supply, institutional, or labor demand

changes.

85

9. The fact that skilled employment grew faster than unskilled employment in the 1980s

appears to rule out supply changes as the dominant factor underlying the growth of

inequality.

10. Such institutional factors as a "frozen" minimum wage and declining unionization

could have played a role in the growing inequality, but they apparently played a

minor one.

11. Both product demand changes and changes in the mix of productive factors

contributed to growing inequality, with the latter changes the dominant force in the

growth of education-related differentials.

12. The growth of contingent-pay plans might underlie the increased dispersion within

human-capital groups, but definitive work has yet to be done.

13. (Appendix) The Lorenz curve and Gini coefficient are related measures of disparities

that are based on groups' shares among the total.

Answers to Even-Numbered Review Questions

2. Assume that the "comparable worth" remedy for wage discrimination against women

will require governmental and large private employers to increase the wages they pay

to women in female-dominated jobs. The remedy will not apply to small firms. Given

what you learned earlier about wages by firm size and in female-dominated jobs,

analyze the effects of comparable worth on earnings inequality among women. (For a

review of relevant concepts, see Chapter 12.)

Answer: The comparable worth remedy will have contradictory effects on the dispersion

of earnings if it is applied only to large private or governmental employers. The reason is

that the employers to which the comparable worth remedy will apply are the highest-

paying employers, but the jobs to which it will apply are among the lowest-paying jobs.

Raising the wages of the lowest-paying jobs will tend to equalize the distribution of

earnings, but because the remedy applies only to the highest-paying firms, there may be

offsetting tendencies. In particular, there may be downward pressure on wages in female-

dominated jobs in the small business sector as employment shifts from sectors

experiencing large wage increases to "uncovered" sectors. Thus, it is possible that the

lowest-paying jobs with the lowest-paying employers will actually experience reductions

in wages that could widen the dispersion of earnings. In summary, women in the very

lowest part of the income distribution might experience wage reductions, while those

slightly above them will experience wage increases; the more dominant of these two

tendencies is difficult to forecast.

4. Proposals to tax health and other employee benefits, which are not now subject to the

income tax, have been made in recent years. Assuming that more highly paid workers

have higher employee benefits, analyze the effects on earnings inequality if these tax

proposals are adopted. (For a review of relevant concepts, see Chapter 8.)

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Answer: If employee benefits are subjected to the income tax, the receipt of

compensation in the form of "in-kind" or deferred benefits becomes less attractive.

Workers now receiving a substantial fraction of their overall compensation in the form of

benefits may decide that they would prefer to have reduced benefits and receive a higher

fraction of their pay in cash earnings. Assuming overall (pre-tax) compensation levels are

not changed by this new law, its main effect will be to shift the compensation of highly-

paid workers away from benefits and toward even higher levels of cash earnings. If by

the "earnings distribution" we mean (as we did in the text) cash earnings, then the effect

of this benefits tax will be to widen the dispersion of earnings in society. Widening the

dispersion of earnings, however, is offset by a narrowing of the dispersion of employee

benefits received, with the result that the overall distribution of total pre-tax

compensation might remain essentially unchanged. (The distribution of post-tax

compensation, however, is more equal than before, owing to the increased taxes paid by

highly-compensated workers.)

6. Discuss the role of geographic mobility in decreasing or increasing the dispersion of

earnings. (For a review of the relevant concepts, see Chapter 10.)

Answer: Geographic mobility is, at least in part, a response to earnings inequality across

geographic areas. People tend to move from areas with low opportunities (wages) to

places where they believe they can improve their earnings, at least in the long-run. Thus,

geographic mobility should tend to equalize earnings across areas -- driving up wages in

low-wage areas (as workers move out) and driving down wages in high-wage areas.

While geographic mobility may do little to shrink the gap between the wages of highly-

educated workers and those of high school dropouts say it does serve to reduce the

disparity of earnings within human-capital groups.

Answers to Even-Numbered Problems

2. Suppose that the wage distribution for a small town is given below.

Sector Number of Workers Wage

A 50 $10 per hour

B 25 $5 per hour

C 25 $5 per hour

Then a minimum wage law is passed that doesn't affect the market in high-wage

sector A, but boosts wages to $7 per hour in sector B, the covered sector, while

reducing employment to 20. Displaced workers in sector B move into sector C,

where wages fall to $4.50 per hour as employment grows to 30. Has wage inequality

risen or fallen? Explain.

87

Answer: There are several ways to measure inequality. On the one hand, the share of

income going to the bottom half of the income distribution has risen (from $250/$750

= .333 to $275/$775 = .355), thus wage inequality has fallen by this measure. On the

other hand, the 80th

-20th

percentile wage ratio has risen (from $10/$5 = 2 to $10/$4.50 =

2.22). There is no unambiguous answer to this question.

Suggested Essay Questions

1. Would a higher minimum wage promote more wage equality? Discuss thoroughly.

Answer. As discussed in Chapter 4, one possible effect of a higher minimum wage is for

the “spillover effect” to cause lower wages in the uncovered sector. In this case, wages

rise for some low-wage workers, but fall for others – and the effects on wage inequality

are ambiguous. (Of course, there are different ways of measuring wage inequality, and

different results could be obtained by different measures. For example, if workers

covered by a new minimum wage were at the 20th

percentile of the wage distribution,

while those who are uncovered are at the 10th

, an 80-20 measure would show

improvement, but a 90-10 measure would indicate greater inequality.)

2. Countries X and Y both have agricultural and industrial sectors. Historically, they

have levied tariffs on each other’s exports, which have had the effect of reducing

trade between the two countries. X and Y now agree to drop these tariffs. Will

greater trade between the two countries lead to increased real incomes in each country?

Will greater trade lead to increased real wage equality within each country?

Answer. As discussed in Chapter 4 and its appendix, moving from restricted to free trade

will have effects similar to technological change (in that the principle of comparative

advantage will lead to more efficient production of goods and services). Technological

change will increase real incomes in both countries, which can now take advantage of

cheaper goods and services. However, technological change does not imply anything

about changes in wage equality. Comparative advantage may call for more of one kind

of worker in a given country to be used, and less of another, depending on the ratio of

marginal product to wages for the two kinds of workers in X and Y (clearly, these

sectoral shifts do not depend on wage levels alone).

88

CHAPTER 15 - UNEMPLOYMENT

This chapter defines the unemployment rate and discusses its strengths and weaknesses

as a measure of economic welfare. Further, it emphasizes that while the unemployment

rate is a stock concept, there is an underlying set of flows into and out of that stock. Thus,

different demographic groups may have different unemployment rates because of

different propensities to quit or be laid off from jobs.

Next, we discuss four general types of unemployment: frictional, structural, demand

deficient, and seasonal unemployment. In the section on frictional unemployment we

discuss search theory and the effects of unemployment benefits on job search. When

analyzing structural unemployment, occupational and geographical imbalances,

government policies, and efficiency wages (including the "wage curve") are discussed.

The section on demand deficient unemployment analyzes wage rigidity, the financing of

unemployment benefits, and policies and adjustments found in Europe.

The chapter also treats the issue of "full employment." The structure of unemployment

rates across demographic groups is presented, and we then discuss effects of the

changing age, race, and sex composition of the labor force on the full employment rate of

unemployment.

List of Major Concepts

1. The unemployment rate is the number of nonemployed people seeking work divided

by the number of people who are in the labor force. While this measure has a number

of serious drawbacks, it remains a useful indicator of labor market conditions.

2. While one can think of a stock of unemployed persons, this stock is constantly

changing, focusing only on the stock masks the highly dynamic nature of labor

markets. Unemployment rates are affected by layoffs and quits, new hires and recalls,

retirees from and new entrants into the labor market. As these flows change relative

to each other, the unemployment rate changes in predictable ways.

3. Frictional unemployment occurs because labor market information is imperfect. It

takes time even in the best of markets for unemployed workers and employers with

job vacancies to find each other. Government efforts to improve the rapidity of the

job-matching process could reduce the extent of frictional unemployment.

4. A period of unemployment can be looked upon as a period when job search can be

undertaken, and the extent to which someone will spend time searching for work

depends upon the expected benefits and costs of continuing search.

5. Since the receipt of unemployment insurance benefits reduces the costs of extra time

spent searching for work, the more generous these benefits are, the longer

unemployed workers will tend to search for jobs. Thus, more generous

89

unemployment insurance benefits may be expected to increase the duration of

unemployment.

6. Structural unemployment occurs when flows of workers into and out of particular

labor markets -- defined by skill or geography -- are impeded. Government efforts to

subsidize mobility and/or job training would serve to reduce the incidence of

structural unemployment.

7. Structural unemployment is also associated with firms' decisions to pay efficiency

wages; in such cases, some workers without jobs "wait" for jobs in the high-paying

sector and do not seek jobs in lower-paying firms.

8. Efficiency wages may underlie the "wage curve" found in almost all countries studied;

this curve plots a negative relationship between the regions' wage rates and their

unemployment rates.

9. Demand-deficient unemployment occurs when the aggregate demand for labor

declines in the face of downward inflexibility of nominal or real wages.

10. There are several reasons for the downward inflexibility of money wages, including

the preference of unions for layoffs over wage cuts, the asymmetry of information

between employers and employees, firm-specific training, risk aversion of older

workers, concerns about status, and implicit contractual agreements that after an

initial period, when the risk of layoff is high, yearly earnings of workers will stabilize.

11. The government's tax treatment of most unemployment insurance benefits and its

failure to perfectly experience-rate the unemployment insurance charges levied on

employers lead to a higher layoff rate than would otherwise prevail.

12. In Europe, cyclical fluctuations in labor demand are more likely to be manifest in

adjustments in hours, not employment levels. One reason for the greater adjustments

in hours of work may lie in the wider use of partial unemployment compensation

benefits in Europe.

13. Seasonal unemployment may be associated with changes in the weather or with

model changeovers, but it is also affected by downward rigidity of money wages and

the government's unemployment insurance program.

14. The full-employment rate of unemployment (i.e., unemployment in "normal" times)

appears to have changed in recent years, in part due to the changing proportion of

women, teenagers, and ethnic minorities in the labor force.

Answers to Even-Numbered Review Questions

90

2. Government officials find it useful to measure the nation's "economic health." The

unemployment rate is currently used as a major indicator of the relative strength of

labor supply and demand. Do you think the unemployment rate is a useful indicator

of labor market tightness?

Answer. There are many problems with using the aggregate unemployment rate as an

indicator of labor market tightness. It provides no information about the number of

individuals who are not actively searching for work because they were unsuccessful in

the past. It tells us nothing about whether the employed are working at jobs

commensurate with their skill levels. It does not distinguish between unemployment of a

skilled adult and unemployment of an unskilled new entrant into the labor force. It tells

us nothing about the number of workers who are employed. Finally, it is sensitive to the

generosity of some social programs, like the unemployment insurance system. It is

consistently measured over time, however, so that – despite its weaknesses – we can

measure changes in labor market conditions from one year to the next.

4. Is the following assertion true, false, or uncertain? "Increasing the level of

unemployment insurance benefits will prolong the average length of spells of

unemployment. Hence, a policy of raising UI benefit levels is not socially desirable."

Explain your answer.

Answer. The social desirability of raising unemployment insurance (UI) benefits depends

on a number of factors. From an efficiency perspective, the costs of higher UI benefits

are the prolonged spells of unemployment they induce (they encourage unemployed

workers to search longer). The benefits of higher UI benefits are the better job matches

they induce, as they provide unemployed workers with the resources to continue to

search for jobs more commensurate with their skill levels. If individuals find higher-

paying jobs that match their skills more closely, output will increase and the probability

that these workers will quit their jobs in the future will decline. The empirical magnitudes

of these various effects must be evaluated before one can decide if it is desirable to raise

UI benefits.

6. In the 1970s Sweden adopted several new labor market policies affecting layoffs.

Three were notable: (1) Plants that provided in-plant training instead of laying off

workers in a recession received government subsidies; (2) All workers had to be

given at least one month's notice before being laid off, and the required time in the

average plant was two to three months; (3) Laid-off workers had to be given first

option on new jobs with the former employer. What probable effects would these

policies, taken as a whole, have on wages, employment, and unemployment in the

long run?

Answer. Policy number one clearly increases the incentives of firms to retain workers

during a recession. Therefore, this policy will probably reduce unemployment associated

with demand deficiency. If the training that is subsidized is useful and geared to market

demands, then the substitution of training periods for periods of unemployment may

91

reduce structural unemployment as well. That is, firms could train their workers to fill

newly created jobs for which their current work force was not trained, or it could use the

subsidy to provide training to its workers that other firms might find useful. This latter

policy might be pursued by firms whose labor demand was shrinking and who might find

it more profitable to induce employees to quit rather than undergo the expense of laying

them off.

Requiring advance notice of layoff to employees raises labor costs because firms are no

longer free to lay off workers the instant marginal productivity slips below the wage rate.

While the short-run effects of this may indeed inhibit layoffs, the longer-run effect is that

the rehiring of labor when the market improves will be discouraged. That is, by raising

the costs of labor, the firm will be induced to scale down its operations and to substitute

capital for labor. The slowing down of the post-recession recall of laid-off workers and

the possibility of reduced labor demand could cause unemployment to rise (or remain)

higher than it otherwise would. Of course, this conclusion would change if wages were to

fall when this new "fringe benefit" of advance notice was mandated.

A requirement that laid-off workers be given first option on any new jobs with the former

employer might prevent such employers from hiring younger, less experienced workers,

and could cause the composition of unemployment to change. That is, the unemployment

rate for older workers might fall and the unemployment rate among younger workers

might be expected to rise as a result of this policy. By constraining firms to hire older,

displaced workers from declining departments in their expanding departments, the

requirement raises labor costs and will tend to cause employment growth to be smaller

than it would otherwise be. This, of course, could contribute to unemployment in the long

run.

8. The present value of benefits in many pension plans are larger if a person retires

before the normal retirement age. In short, there is a large inducement for many

private sector workers to retire early. What effect will increasing the inducements to

retire early have on the unemployment rate of older men? Fully explain your answer,

making use of the assumption that retired workers withdraw from the labor force and

do not seek or obtain other jobs.

Answer. It is possible that increased inducements for early retirement will increase the

unemployment rates of older workers. The reason for this is that they may induce older

workers who are currently employed to withdraw from the labor force earlier than they

otherwise would, thereby increasing flows from employment to "out of the labor force."

When flows from employment to out of the labor force are increased, other things equal,

the unemployment rate will rise because there is a fall in the labor force without a

corresponding fall in unemployment.

It is possible, of course, that the older workers deciding to retire early are predominantly

those who have just been laid off -- perhaps permanently -- by their employers. They

may believe that, rather than continuing to search for work, they would be better-off

accepting their pension and dropping out of the labor force. Obviously, the more

92

generous their pension is prior to normal age of retirement, the greater is the likelihood

that they will drop out of the labor force after layoff. Thus, it is impossible to say whether

more generous early retirement benefits tend to increase or reduce the unemployment

rate of older men.

Answers to Even-Numbered Problems

3. Suppose that initially the Pennsylvania economy is in equilibrium with no

unemployment:

Ls = -1,000,000 + 200W and Ld = 19,000,000 – 300W, where W = annual wages and L

= number of workers. Then structural unemployment arises because the demand for

labor falls in Pennsylvania but wages there are inflexible downward and no one

moves out of state. If labor demand falls to Ld = 18,000,000 – 300W, how many

workers will be unemployed in Pennsylvania? What will be its unemployment rate?

Answer: Find the initial wage and employment level by solving as below:

-1,000,000 + 200W = 19,000,000 – 300W, so

500w = 20,000,000, and W = $40,000

With W = $40,000, L = 7,000,000. Next, find the gap between Ls and Ld at W = $40,000

after the labor demand curve shifts:

Ls = -1,000,000 + 200x40,000 = 7,000,000

Ld = 18,000,000 - 300*40,000 = 6,000,000

This gap, Ls - Ld, shows that unemployment equals 1,000,000. The unemployment rate

is (1,000,000/7,000,000)x100 = 14.3%.

Suggested Essay Questions

1. “With the growth of free trade, Mexican employers have sought to reduce union

control over internal labor markets, and they have eliminated promotion by seniority,

rules against subcontracting, and restrictions on the use of temporary workers – all in

the name of greater flexibility.” Would you expect greater employer flexibility in

hiring and assigning workers to increase or decrease unemployment in Mexico?

Explain.

Answer. The level of unemployment in any country is a function of how fast workers

flow into unemployment as compared to how fast they flow out. The above changes in

Mexican employment conditions will probably tend to increase flows into unemployment,

but by allowing employers to be more flexible, they lower the costs of creating new jobs.

Hence, flows out of unemployment will tend to increase as the pace of job creation is

enhanced. Even the flows into unemployment will be reduced, however, if the changes

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permit labor costs to be more flexible in a downward direction during periods of falling

demand.

2. One student of the labor market effects of free trade argues that the government

should offer “wage insurance” to workers who lose jobs because of free trade. Under

this proposal, the government would replace a substantial portion of lost earnings if,

upon re-employment, eligible workers find that their new job pays less than the one

they lost. This wage insurance would be available for up to two years after the initial

date of job loss. Would this wage insurance program reduce unemployment?

Answer. Wage insurance should cause unemployed workers to take offers they would

normally have rejected, thus increasing the flows out of unemployment and into jobs –

which, by itself, would reduce unemployment. Two factors might serve to increase the

flows into unemployment, however, which could increase the level of unemployment.

First, if workers take jobs hastily (the clock starts ticking upon job loss), they may be

poorly matched with their employers – and may quit or be fired after the insurance runs

out. Second, employers may be less reluctant to lay off workers, knowing that they have

wage insurance for two years after layoff.

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