Total Video Time: 0 minutes
This module consists of lecture notes — no lecture videos. (But you do have the Asarta/Butters videos that you should watch first before reading these lecture notes.) If anything is confusing, please e-mail me or post a question on the discussion board on D2L.
Note also that I use the words “inputs” and “resources” interchangeably. Asarta/Butters consistently refers to these markets as resource markets, so when you read “input markets” here, don’t let that confuse you — we’re talking about the same thing.
Until now, everything we have been doing has been dealing with output markets: the markets for wheat, gasoline, cigarettes, automobiles, pharmaceutical drugs, etc. The idea was to understand how market structure affects prices and, therefore, affects consumers. But we must also realize that it’s not just prices that determine how well off you are — your income matters just as much. So in this module we examine what determines wages and, therefore, income for different people.
We’ll find that some of wage differences are based on solid economics, while some of it is unexplained. We’ll also find that what matters is not just your inherent productivity — it’s also the price of the product you produce, as well as the other options you have. For example, business school professors often earn more than history professors; this is not because they’re better teachers or researchers, but because they have more lucrative private-sector offers, so if universities don’t pay them more, none of them would come teach.
It’s also in labor markets where people’s understanding of economics is often sacrificed to their understandings of fairness. Economists treat labor like any other commodity — after all, firms have choices between workers and machines, so we should treat them similarly. However, in the grand scheme of things, most of us (even some economists!) know that people are more important than machines. Therein lies the tension. For example, some people will look at the fact that they contribute $20 per hour to their firm’s revenues but are only paid $15 per hour and then say, “I’m being exploited!” I have two responses to that. First, if your employer doesn’t make any money from hiring you, why should they bother hiring you? If they have to pay you $20/hour so you can generate $20/hour in revenues, what’s in it for them?
Second, your concept of “exploitation” is just what we call “consumer surplus.” Remember, firms are buying labor (renting it, actually; slavery is illegal) and people supply labor, and individuals own firms. So if firms are willing to pay more than they actually have to pay, the people who own the firms get consumer surplus. If you think consumer surplus is wrong for the owners of firms in this setting, then to be intellectually honest you would also have to argue that it’s wrong for you to get any consumer surplus on anything you buy. (You shouldn’t get special treatment just because you don’t own a company, right?) That would require that for the cup of coffee that you’re willing to pay $4 for but only have to pay $2 for, you have to shell out an extra $2 just so that you’re not exploiting your local coffee shop. You would have to pay whatever you’re willing to pay for everything you buy — which would end up being a lot of money. Your income wouldn’t go nearly as far and you would be worse off as a result. Now you know how your argument of “I’m being exploited!” sounds to someone running a company. Remember: consumer surplus works both ways — in output markets and in input markets.
Is it fair that Alex Rodriguez is paid $25 million per year while over a billion people in this world live on less than $2 per day? Probably not. But I don’t run the world, and neither do you. Wages are determined in labor markets based on productivity and prices of output. The result isn’t always what anyone would consider “fair.” But the fact that a billion people are poor has ABSOLUTELY NOTHING to do with Alex Rodriguez’s salary. Is it fair that people who live in Jamaica get to watch beautiful sunsets every day while I’m in St. Cloud freezing my butt off half of the year? No, but the two have absolutely nothing to do with each other. Denying them a sunset doesn’t make me any warmer, just as taking money from Alex Rodriguez wouldn’t make a dime’s worth of difference to all the poor people of the world. (Now, if A-Rod wants to donate money to charity, that’s entirely up to him. Free-market economists would argue that charity is one possible solution to poverty; limiting the wages of wealthier people will just reduce the supply of labor and decrease income overall, reducing A-Rod’s ability to donate money to charity or do anything else that might help other people.)
One final reason why students often get emotional about labor market issues (poverty, income inequality, etc.) is because many people in society believe that your “worth” depends on your income. After all, when the federal government paid money to the families of victims of the 9/11 terrorist attacks, the investment banker at Cantor Fitzgerald was determined to be worth more than the busboy at Windows on the World. All life is inherently valuable, but there are different economic values placed on people based on their productivity. It sounds wrong, but it’s something we must do. To say that “every life is priceless” is meaningless when trying to determine how much a company should pay when its product accidentally kills someone or when a drunk driver kills an innocent bystander. Do some people make more money than others? Yes. Does that mean their family would get a larger judgment if a court determined someone wrongfully killed them? Probably. Does it mean they’re “better” than someone who earns less? Not at all. Try to separate “economic value” from “moral value” and hopefully the issues in this chapter will become a bit more clear.
Input Markets vs. Output Markets
When we talk about input markets, we have to remember that supply and demand are changing. Firms are on the demand side now: they demand inputs in order to produce output. Households are on the supply side: households own labor, funds for investment, and land that the firm needs to purchase from them. We’re going to end up using the same kind of marginal analysis. I want to briefly show you how input market analysis compares with output market analysis.
In output markets, when consumers decide how much of a good to buy, they compare the marginal benefit of the good (marginal utility derived from consuming the good) to the marginal cost of buying the good (the price). When firms decide how much of a good to supply, they compare the marginal benefit (marginal revenue) of the good to the marginal cost of producing the good.
When we flip this around for input markets, we can see that the situation is very similar. Now consumers decide how much of an input to supply by comparing the marginal benefit of supplying the input (the price of the input) to the marginal cost of supplying the good (the lost utility from consuming the input). Firms decide how much of an input to buy by comparing the marginal benefit of buying the input (the marginal product of the input and the price of the output it produces) to the marginal cost of buying the good (the price of the input).
We will start by looking at the labor market, because it provides a good introduction into input markets, and the analysis that we do here holds for most inputs in general.
The demand for labor is a “derived demand” because it depends on how much output the firm is producing. Firms first decide how much to produce by setting MR equal to MC and then decide how much labor they need to produce that quantity of output. We have already seen numerous short-run decisions that firms must make. First, we’ve seen that firms must decide how much output to produce by comparing MR with MC. Second, we’ve seen that firms must decide whether to produce or shut down if they are incurring losses. The decision of how much labor to hire is another short-run decision firms must make. There are three relevant factors that firms must consider when deciding how much labor to hire.
– Marginal Product of Labor (MPL). The MPL is the additional output produced by one additional worker. What does the MPL look like, generally? This is directly related to marginal returns. When we were trying to determine what the firm’s MC curve looked like, we went through examples and saw that when the first few workers are hired, they are more productive because of specialization. But eventually crowding occurs because of fixed inputs, and productivity starts to decrease. Thus, the MPL curve starts out increasing and then starts to decrease as the firm hires more labor.
– Marginal Revenue (MR). Marginal revenue is how much a firm can sell its additional output for.
– Wage (w). The wage is the price of labor.
Marginal Revenue Product of Labor. If we multiply MPL by MR, the result is the marginal revenue product of labor (MRPL), the amount of additional revenue created by an additional worker. You can see this in the example below:
MPL = change in Q/change in L
MR = change in TR/change in Q
MRPL = (change in Q/change in L)*(change in TR/change in Q) = change in TR/change in L
When the marginal revenue curve facing a firm is perfectly horizontal (as it is in a perfectly competitive industry), MRPL = MPL*P. (Note: this implies that perfectly competitive industries will hire more labor than monopoly industries. In a PC industry, MR = P so when a firm hires another worker to produce output, it has no impact on the market price. In a monopoly industry, MR < P, so when a firm hires another worker to produce output, it has to lower the price it charges to sell that extra output. This should not be a surprising result: if PC industries produce more output than monopoly industries, they’re going to need to use more labor to do so.)
Suppose that if a firm hires a worker for one hour, that worker will be able to produce two units of output that will each be sold for $6. In this case, the MPL is 2 units of output, the MR is 6, and the MRPL is $12. If the wage is lower than $12, the firm will hire the worker because its increase in revenues will be greater than its increase in costs (the hourly wage it pays this worker). Thus, the profit-maximizing decision for firms is to hire labor until w = MRPL. This decision is very similar to the decision that firms make to produce the level of output such that MR = MC.
Below are two graphs, the MPL and the MRPL. The MPL curve is upward-sloping initially, then diminishing marginal returns set in and the MPL slopes down. In a perfectly competitive industry, the MRPL curve will have the same shape as the MPL curve,. However, we place dollars on the vertical axis instead of units of output because we are measuring revenue. In our example before, if the peak of the MPL curve was at 5 units of output, then the peak of the MRPL curve would be at $30. You are just taking the MPL curve and multiplying it by the price of the output, scaling the curve up.
In the graph below, if the wage is equal to w1, the firm will hire L1 units of labor, the amount where the wage crosses the MRPL curve. If the wage is equal to w2, the firm will hire L2 units of labor, the amount where the new wage crosses the MRPL curve.
Thus, we can infer from the graph above that the downward-sloping part of the MRPL curve is the labor demand curve for a firm.
Individuals face a trade-off between labor and leisure. For the purposes of this analysis, we assume that individuals can decide how many hours they want to work. In reality, you might not be able to decide that you want to work exactly 26 hours a week, but you can probably choose between 20 and 40, and if you want more than that you can get a part-time job.
One important thing to realize is that there is a cost to leisure when you can choose how many hours to work. The cost of leisure is an opportunity cost: the wage that you are foregoing by not working for that hour.
So now we want to see what happens to the amount of hours that people want to work when the wage increases. When the wage increases, the price of leisure increases, so you substitute away from leisure and you work more. This is the substitution effect: you are substituting away from leisure because its price has increased. But when the wage increases, your income increases, so the consumption of normal goods (including leisure) increases, meaning that you work less. This is the income effect of a wage increase. The question we have to answer is, which effect is stronger? At most wages, this substitution effect dominates and the supply curve is upward-sloping, but at very high wages, the income effect dominates and the supply curve becomes backward-bending (see graph below).
Why might the labor supply be backward-bending at high wages? This happens if you have a target level of income. Say you decide that when you make $200,000 per year, that’s enough for you. If you’re already making $200,000 per year and your hourly wage increases, you can afford to work fewer hours and still make the same $200,000. This is why lawyers and doctors take afternoons off to play golf: they are already making enough money, so they don’t have to work as many hours.
Individual labor supply curves may not look like this because most people cannot choose how many hours they work. However, when we take an aggregate of all workers in the economy, the labor supply curve is smooth and upward-sloping.
Equilibrium in the labor market occurs where the labor demand curve crosses the labor supply curve. The market labor demand curve is the sum of all individual firms’ labor demand curves.
Inputs and Outputs
Any change in input markets is likely to have an effect on output markets through costs. For example, higher wages in the labor market drive up a firm’s variable costs, shifting the MC curve up and reducing supply in the industry. The result: higher prices for the output. This article theorizes that the price of one key input determines whether or not McDonald’s sells the McRib.
Differences in Wages
Based on this analysis, there are two reasons for differences in wages across markets: differences in labor demand, and differences in labor supply. First, we’ll look at differences in labor supply. What kinds of things determine individual labor supply?
1. Other sources of income. The reason that people work is in order to earn an income, primarily. Given that, the higher one’s wealth is, the less that person will work. Similarly, in two-person families, when one person earns a high income, the other person usually does not work. Decreasing the primary wage earner’s income increases the likelihood that the second person in the household will seek a job.
2. Nonmonetary factors. Some jobs have a work environment that are just less glamorous than others, and as such people are less likely to want them. Driving a garbage truck is not something that many people want to do, and as a result the supply of labor is lower in fields like this. Similarly, there are millions of people out there who want to be an actor or actress, which is one reason why the wages of these people (who aren’t movie stars) is relatively low. They are willing to trade off money that could be earned in another career for the other nonmonetary factors that the entertainment industry offers them.
3. Value of job experience. The more valuable the job experience is, the more likely people are to work there. For example, lawyers clerk with judges even though the pay is relatively low because of the experience they will earn. A friend of mine graduated law school and is working for the Department of Justice’s Antitrust Division for a few years because, after he’s done, he can work for private companies and have an insider’s perspective on antitrust cases.
4. Training/education expenses. In addition to making workers more valuable, training and education are a cost that can affect labor supply. Part of the reason that lawyers earn so much money is because it costs about $100,000 to go to a decent law school. That is a significant impediment to many people, so the supply of lawyers will be lower than it would be if law school were much more inexpensive.
Differences in demand can also explain differences in wages. People that are more productive will earn more than people that are not. And people working in industries in high demand (and therefore high prices) will also earn more. In addition to decreasing supply, education also results in an increase in demand because it makes you more productive.
Last, but certainly not least, is discrimination. While it is decreasing and has been for some time, there is arguably still some discrimination against women and minorities. But remember, discrimination doesn’t mean that black people earn less than white people or women earn less than men. It means that two people who have the same qualifications (experience, education, talent, etc.) receive different wages.
Inequality in Labor Markets
You often hear that women earn a fraction of what men earn. Guess what? It’s true. In the year 2000, women earned 73% of what men earned. In 2008, it’s approximately 78%. This wage gap has closed from 64% in the last twenty-five years. But this statistic is a little misleading. It’s just taking average male income compared to average female income, and not accounting for anything economically justifiable that might explain those differences.
First, if you’re going to prove discrimination, you should compare workers in the same profession. If you showed that male doctors earned more than female doctors, that would be a stronger case than just looking at averages. If more athletes and movie stars are male, and these people earn many times more than the average salary, then if you compare average salaries by gender you’ll find men earning more — but that does not mean there is discrimination except perhaps in sports and entertainment (and even then, the argument requires further exploration). Part of the reason that women earn less than men is that more teachers and nurses are women, and more professors and doctors are men. This is referred to as “occupational segregation”: people choose fields where people like them are already employed. Much of this is largely the result of societal norms, not blatant discrimination.
Perhaps labor market outcomes differ because of discrimination. If you want to make that argument, you can’t just assume it — you have to PROVE it. And two economists did just that: Cecilia Rouse and Claudia Goldin did a study in 2000 where they examined the difference in composition of symphony orchestras before and after blind auditions were imposed. Before blind auditions, the symphony was predominantly male. Afterwards, when judges could not see the gender of the person playing the instrument, it approached 50% male/50% female. This is a sign that discrimination was occurring in this labor market and a mechanism was designed to eliminate it. So I’m not saying that discrimination does not exist — I’m saying that less of it exists today than a decade ago, and I’m saying that an observed difference in outcomes does not mean discrimination is the cause.
Some of the women reading this may think I’m being too dismissive of discrimination. Not at all. I’m just saying that differences in outcomes do not mean discrimination is occurring — you have to investigate further. For example, many studies have shown that GPAs of women in college are higher on average than GPAs of men. What can we infer from this?
1. Perhaps women enroll in less challenging majors. That’s one possible explanation men like to imagine. Sorry, guys: research that controls for major choice finds that when you compare men and women in the same major, women tend to have better grades.
2. Maybe women are smarter than men. (The women in my classes seem to think that’s the answer…)
3. Maybe women get special treatment from their professors, who are overwhelmingly male.
4. Maybe women work harder in school and take their education more seriously, while men tend to drink and party more.
While I don’t have any studies to back this up, I would bet my money on #4. When I was co-coordinator of the Student Learning Center’s Economics Tutoring program at U.C. Berkeley, more than 2/3 of the students that came in for tutoring were women. Men tended to be more obstinate, perhaps more proud, and did not seek help nearly as often.
Any or all of the possible explanations offered above could factor into the GPA disparity. So to conclude that simply because the male GPA is lower than the female GPA, men are being treated unfairly, is a preposterous conclusion to make without further analysis. That’s all I’m saying here.
Okay, so we’ve established two things: 1) you have to compare workers in the same profession, and 2) an observed difference in outcome must be PROVEN to be discrimination and cannot just be assumed.
Suppose you observe differences in wages within a profession. What, other than discrimination, might explain this? Education and experience. There is strong economic reasoning supporting the idea that the more years of education and experience on the job a person has, the more productive they will be, and the greater the demand for their labor will be. Thus, the source of the wage differential lies less in sexist attitudes and more in differences in education and job market experience. This is one reason why the gap in wages is closing: more women graduate from college and women are gaining more experience in the labor market.
Once you account for these differences, women’s wages increase to around 95% of men’s wages. True, there is still a 5% differential, and some of this may be due to discrimination, but to say that the entire 30% difference in hourly wages is due to discrimination is factually incorrect and designed to mislead.
Interdependence of Labor Markets
One thing that’s important to realize is that labor markets are intertwined with each other. For example, I could potentially be in two labor markets: that of economics professors and that of people who have PhDs and work in the private sector. I have made a choice to be a college professor by comparing the relative attractiveness of both types of jobs and their relative pay. But if there were a substantial increase in the market for private-sector economists, it might be enough to induce me to jump markets and leave my current job.
So let’s keep that kind of thing in mind and make some broad generalizations about the economy to see what has been happening to income inequality in the last few decades. Suppose that there are two different types of labor in the United States: skilled and unskilled. Skilled workers are more productive, so the demand for them is higher. Also, becoming skilled requires going to school (college or some other training), which can be expensive, so if we hold everything else equal, the supply of skilled workers will be smaller than the supply of unskilled workers. These two facts imply that the wages of skilled workers will be greater than the wages of unskilled workers.
President Clinton’s HOPE and Lifetime Earning tax credits were designed to make it more affordable to attend college — thus, it becomes easier to become a skilled workers. What effects should this have on the wages of skilled and unskilled workers? When an unskilled worker becomes trained and gets a college degree, he now becomes a skilled worker — he jumps markets. This does two things: it increases the supply of skilled workers and decreases the supply of unskilled workers. This should result in lower wages for skilled workers (or at least wages that don’t increase as fast), and higher wages for unskilled workers: if everyone in town leaves to go to college, McDonald’s is going to have to start paying higher wages just to get someone to man the cash registers.
However, when one looks at the actual numbers, the gap between the wages of skilled and unskilled workers has been growing in the last two decades. In 1980s, the average wage earned by college graduates was 40% higher than those with just a high school diploma; now it’s over 80%. There are several explanations for this. This first is that the demand for skilled workers in fields like computers, engineering, and medicine has risen much more than the demand for unskilled workers in the service sector. The second is that with globalization, unskilled workers face more competition for their jobs, increasing the supply of their labor and driving their wages down.
Hint on Discussion Question 11.1 (which leads into a longer discussion).
An income tax is a tax on labor supply: the only way to avoid income taxes is to not work. So it might be easier to first consider a situation where labor is not taxed, and then see what happens when workers are taxed when they work. This should shift the supply curve up: we demand higher wages from our employers because we know that, after taxes are taken out, if we don’t we’ll end up with less.
This kind of analysis has actually led some to argue that universal health care coverage won’t really make firms better off. The standard argument is that American firms are at a competitive disadvantage with respect to other countries because their governments pay for their employees’ health care, but American firms have to pay for theirs. Thus, with higher costs, they have to charge higher prices and they can’t compete as well in global markets.
However, one has to consider that what should matter to employees is not just the income that you earn, but also the benefits that you receive from your employer. While incomes have been relatively stagnant for many in the middle-class in the last decade, total compensation has increased because health care benefits have increased (plans are getting more expensive and most employers are picking up the tab for most of it). So if suddenly you learn that your boss will no longer have to pay for your health care because Uncle Sam is going to pay for it, many people will probably go to their bosses and ask for a raise. Thus, universal health care won’t immediately make American firms more competitive because it should lead to higher wages for employees because they want to keep their total compensation equal (especially if their taxes go up to pay for government-provided health care).