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The Labor Market
Lesson 13


Why Do Earnings Differ?

1. Productivity - output per worker.

  • Productivity growth is the source for real income growth.
    • In 1997, U.S. workers were twice as productive as U.S. workers in the 1950s.
    • Workers' income also doubled.
      • Human capital - knowledge increases job productivity.
        • Education is increasing.
      • Use more physical capital.
        • Automation - machines that reduce the amount of labor required.
          1. Permits larger output and higher income levels.
          2. Will be used if it reduces costs.
          3. May reduce employment in a specific industry.
        • This excess labor can be employed in other areas.
      • Accountants - can handle more accounts with a computer than paper & pencil. His output and salary are higher.
Blue arrow U.S. worker is 15 times more productive than a worker in China or India and the U.S. has a higher standard of living.

2. Why do earnings differ?

  • 4/5 of national income is earned by employees.
  • 1/5 of national income is earned by interest, rents, & corporate profits.
    • Returns to capital.
  • U.S. workers' income is ranked towards the top in the world.
  • Wages vary widely even within the same occupation, education, and intelligence.
    • Physicians - $100 per hour.
    • Unskilled labor - $6.00 per hour.
  • Earnings would be equal among all people if:
    • All individuals are identical.
    • All jobs are equally attractive.
      • Janitor vs. office job.
    • Workers are perfectly mobile among jobs.
      • Ex: If Tulsa has the highest paying jobs in country.
      • Workers move there because of higher wages.
      • Supply of labor (i.e. workers) increases.
      • Wage rate decreases until wage rates are equal in all regions.

3. Skilled / unskilled earning differences.

  • More productive workers earn more
    • Produce more parts per hour, sell more products, etc.
    • Employers pay wages based on productivity
    • Wages = MRP
      • MRP - Marginal Revenue Product.
    • Employers have greater demand for skilled labor
      • Skilled workers are productive than unskilled labor
    • The supply is less for skilled workers than unskilled
      • Education & training have costs
Demand for Labor Supply of Labor
Wages Wages
The labor demand for skilled and unskilled workers The labor supply for skilled and unskilled workers
# of labors # of labors
  • Putting the demand and supply together for skilled and unskilled workers yield the graph below.
Labor Market
The wage rates for skilled and unskilled workers
# of laborers
Blue arrow Skilled labor earns higher wages than unskilled.

4. Tournament pay - the top-ranked person receives the big payoff, wages > MRP. Person ranked second earn much less.

  • Strong incentive to become the best.
  • Only applies to sports, CEOs, and entertainment stars.

5. More education leads to higher earnings.

Full-time Workers in 2005 Men Women
High School $40,112 $28,657
Bachelor's Degree $75,130 $49,326
Master's Degree $95,794 $59,569
PhD $116,657 $83,141

Source: 2008 Statistical Abstracts of the United States, Table 681

  • More education may reflect:
    1. Greater native ability.
    2. More intelligence.
    3. More motivation.
  • The supply for doctors and engineers is limited relative to demand.
    • Their wages are high.
  • Signals - indirectly provides information to employers.
    • Employers - too costly to measure abilities.
    • Degree provides information.
    • Probabilities:
      • College educated tend to be smarter or more motivated.
      • Grades in courses:
        • Calculus - B
        • History - A
    • Previous work experience.

6. People have different preferences.

  1. Some work 2 jobs.
  2. Some do not work at all.
Blue arrow People motivated by money will more likely pursue more education and training to obtain higher wages.

7. Earnings differential due to nonidentical jobs.

  • Nonpecuniary job characteristics - nonwage factors that are important:
    • Pecuniary - relating to money.
    • Working conditions.
    • Prestige.
    • Location.
    • Employee freedom.
      • FBI - wants agents with advanced degrees, e.g. lawyers, accountants, bilingual people, strong technical backgrounds, etc.
      • Pay is low - start around $27K
      • Employees attracted to the strong prestige.
  • Compensating wage differentials - undesirable working conditions.
    • Job risk.
      • Washing windows on 60-story building.
    • Job location.
      • Coal miner.
    • Working hours.
      • 3rd shift pays more than 1st and 2nd.

8. Labor may be immobile, causing wage rates to differ:

  • Costly to move to new location.
  • Costly for training.
  • Specialized labor.
    • Example: Internet grew over night.
      • Wages for webmasters were very high in the beginning.
      • Wages decreased as more people learned to design webpages.
  • Institutional barriers.
    • Minimum wage
      • Trouble for low-skill labor.
    • Occupational licensing.
      • Medicine, truck drivers, lawyers, CPAs, etc.
    • Labor unions
      • Restrict supply of labor.

9. Wage discrimination - minorities or women.

  • Dual labor market: White male and minority/female labor markets.
  • Employers prefer "white males:"
    • Demand for white males increases.
      • Wages increases.
      • Number of employed white males increases.
      • Offered "good, high-paying jobs."
Labor Market
The wae rates for whites and minorities
# of laborers
  • Employer discriminates against minorities and females.
    • Demand for minorities and females decreases.
      • Wages decreases
      • Number of employed minorities/females decreases
    • Offered "Bad, low-paying jobs."
    • May also limit education or training.
  • Customer-based discrimination - customers can discriminate, causing hardship on professional minorities and females
    • Very difficult to correct.
      • Female dentist.
      • Hispanic doctor.
      • African American CPA accountant.
  • Blue arrow Firms that discriminate have lower profits, because they pay higher wages to white males.

    Competitors can hire minorities and females to reduce labor costs and earn higher profits.

    • Measure the extent of discrimination.
      • Table has average wage rates for different ethnic groups
    2005 Male Female
    White $43,078 $23,235
    African-Americans $25,205 $20,282
    Mexican-American $25,889 $14,571
    Asian $43,801 $24,739

    Source: 2008 Statistical Abstract of the United States, Table 683

    • Different ethnic groups have different characteristics.
      • Statistics are not adjusted for:
        • Education
        • Work experience
        • Union status
        • Location - minorities concentrate in urban areas.
        • Marital status.

    10. Gender discrimination

    • Women working full-time earn about 75% of what males earn, even after adjusting for education, age, and marital status.
    • Participation rates.
      • 37.6% of women worked in 1960.
      • 60.5% of women worked in 1997.
        • Married women account for most of this increase.
    • Women traditionally worked in four occupations.
      • Clerical workers.
      • Teachers.
      • Nurses.
      • Food-service workers.
    • Earnings differences:
      • Employment discrimination.
      • Family specialization.
        • Women:
          • More flexible hours.
          • Temporary leaves from the labor force.
        • Men:
          • Continuously worked.
          • Accepted jobs with long hours, out-of-town travel, etc.
    • More women are earning degrees in:
      • Accounting
      • Law
      • Pharmacy
      • Dentistry
      • The earnings gap between men & women will narrow.
    Blue arrow There is economic incentives for firms to hire women to lower costs and increase profits. Wages should become equal for men and women.

    11. Principal Agent Problem -
    • Principal Agent Problem
      • Firm's goal is to earn a profit.
      • Firm hires workers to help achieve this goal.
      • Workers should contribute and help firms achieve this goal by working
        • Some workers may shirk, i.e. work less than full productivity
    • Correct shirking
      1. Piece rate - worker is paid by how many pieces he makes
        • Negative - produce more parts for lower quality
      2. Commission - worker earns a percentage of the sales
        • Real estate agents, insurance agents, stockbrokers, and retail sales person
        • Negative - fraudulent sales or questionable behavior
      3. Royalties - artists and authors receive a percentage of the sales
      4. Bonuses/profit sharing - additional payment if firm does well
        • Negative - bad workers also free ride and get bonuses
      5. Stock options - workers have the option to buy their company stock for a good price
        • Workers may work harder, if the value of their stock increases
      6. Efficiency wages - an employer pays higher than average wages
        • Increase workers' morale and they work harder
        • Reduce worker turnover

    The Economics of Fringe and Mandated Benefits

    1. Two components of employee compensation.

    • Money wages.
      • Real wage rate - the wage rate is adjusted for inflation.
      • Ex: Inflation is 5% and workers' wages increase by 3%.
        • Real wage decreases by 2%
    • Fringe benefits.
      • Health-care.
      • Pensions.
      • Childcare services, etc.
    • Employer hires if: MRP (benefits) > wages + fringes.
    • Employers attract workers by offering good fringe benefits.
      • Employer's benefits:
        • Group savings.
          • Example: It is cheaper to buy 1,000 employees insurances as a group than purchasing policies individually.
        • Tax savings.
          • Employer transfers more "compensation" to workers by lowering taxable income and increasing nontaxable fringe benefits.
    Blue arrow Employers & employees will structure the compensation package that transfer the highest value to employees for the lowest costs.

    2. Mandated benefits - states and federal government passed laws requiring employers to provide specific benefits.

      • Health insurance.
      • Parental leave.
      • Childcare services.
    • Proponents - protects employees who work for firms that provides no fringe benefits.
    • Critics -
      1. Force employees to purchase benefits and receive lower wages.
        • Reduces employers' flexibility.
      2. Increase labor costs, which reduce employment.
        • Workers will not be hired if:
        • MRP < wages + fringes + mandated benefits.
      3. Mandated benefits can be inefficient.
        • No savings for buying insurance as a group.
        • No tax advantages.

    Different Labor Markets

    1. Competitive labor markets - were shown in the last lecture

    2. Monopsony - a single buyer dominates the buyer's side of the market

    • Examples - a large employer that dominates employment in a small town
      • Lumber mill in a rural Arkansas town
      • Textile mill in rural Maine town
      • Silver mine in Montana
      • Fish processor in Alaska
    • Specialized employment
      • Small towns have only one hospital, school district, newspaper, etc.
      • Limited options for teachers, nurses, building trades, newspaper employees
      • A large city may have several of each type
    • Model assumptions
      • One buyer
      • Labor is immobile
      • Employer has influence over the wage
    • Supply function (S) - workers supply their labor
    • Firm demands workers, which is the MRP
      • MRP is the workers' contribution to the firm
    • Firm is small and the only one
      • Each worker the firm hires raises the marginal cost (MC)
      • MC lies above the labor supply function

    A monopsony's demand function

    • Results
      • Competitive market - firm hires Lc and pays wc
        • Workers earn their full contribution to the firm
      • Monopsony market - firm hires Lm and pays wm
        • Workers contribute Wrent, but earn wm
        • rent - firm has power that it uses to enhance profits, etc.
      • Conclusion - monopsonist hires fewer workers and pays them less as compared to a competitive market

    3. Labor Unions - labor union acts like a monopoly by uniting all workers into one entity

    • Enhance demand - labor unions help expand demand for products made by unions
      1. Public campaigns - "Buy American"
      2. Political lobbying
        • Teachers' Union lobbies for more money, job security, etc.
      3. Encourage government to build a stadium, highway, or expand airport
        • Construction jobs tend to be union
      4. Lobby for higher minimum wage
        • Wage differential between union and minimum wages becomes smaller
      5. Demand for product causes the firm to demand more labor
        • firm can pay higher wages and higher more workers

    Labor union's demand function

    • Restrict labor supply
      1. Lobby government
        • Restrict immigration
        • Compulsory retirement
        • Enact a shorter work week
        • Reduce child labor
      2. Crafts union - restrict workers with special skills
        • Carpenters, brick masons, or plumbers
        • Union has agreement with employer, so employer only hires union workers
          • Unions use strikes
          • Union gets workers to stop working, so firm cannot make anything
        • Unions have
          • Long apprentice programs
          • High initiation fees
          • Limit new membership
      3. Occupational licensing - grants a worker permission to work in a particular occupation
        • Lawyers
        • Barbers
        • Physicians
        • Plumbers
        • Pest control

    A labor union's supply function

    • Bilateral monopoly - a market with one buyer and one seller
      • We do not know what wages or the amount of labor a firm hires
      • Each side has power
        • Possible the outcome is close to competitive as powers cancel
        • The party with the most power wins and gets to determine the wages and number of laborers hired


    • productivity
    • human capital
    • automation
    • tournament pay
    • signals
    • nonpecuniary job characteristics
    • compensating job differentials
    • principal agent problem
    • real wage rate
    • mandated benefits
    • rent
    • bilateral monopoly

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