Chapter Outline and Learning Objectives

17 The Markets for Labor and Other Factors of Production CHAPTER Chapter Outline and Learning Objectives

Why Did the San Diego Padres Trade Their Best Player to the Boston Red Sox? By the end of the 2010 season, Adrian Gonzalez had become one of the best players in Major League Baseball (MLB). The Padres had the second-lowest payroll of all MLB teams and could not afford to sign Gonzalez to a long-term contract. The Padres traded Gonzalez for three young—and inexpensive—players. Shortly after the 2011 season began, the Red Sox signed Gonzalez to a seven-year contract worth over $150 million. Issues of fairness arise often in labor markets. When an athlete signs a contract for millions of dollars, people often wonder: “Why should someone playing a game get paid so much more than teachers, nurses, and other people doing more important jobs?” People often view the labor market as the most important market in which they participate. AN INSIDE LOOK on page 628 applies the demand and supply model to the rapidly rising salaries of NCAA Division 1-A basketball coaches.

Economics in Your Life How Can You Convince Your Boss to Give You a Raise? Imagine that you have worked for a local sandwich shop for over a year and are preparing to ask for a raise. You might tell the manager that you are a good employee, with a good attitude and work ethic. You might also explain that you have learned more about your job and are now able to make sandwiches more quickly, track inventory more accurately, and work the cash register more effectively than when you were first hired. Will this be enough to convince your manager to give you a raise? See if you can answer this question by the end of the chapter: How can you convince your manager that you are worth more money than you are currently being paid? Factors of production Labor, capital, natural resources, and other inputs used to produce goods and services.

The Demand for Labor 17.1 LEARNING OBJECTIVE Explain how firms choose the profit-maximizing quantity of labor to employ.

Derived demand The demand for a factor of production; it depends on the demand for the good the factor produces. Apple’s demand for the labor to make iPhones is derived from the underlying consumer demand for iPhones. As a result, we can say that Apple’s demand for labor depends primarily on two factors: 1. The additional iPhones Apple can produce if it hires one more worker 2. The additional revenue Apple receives from selling the additional iPhones The Marginal Revenue Product of Labor Marginal product of labor The additional output a firm produces as a result of hiring one more worker. Because of the law of diminishing returns, the marginal product of labor declines as a firm hires more workers.

The Marginal Revenue Product of Labor Marginal revenue product of labor (MRP) The change in a firm’s revenue as a result of hiring one more worker. Figure 17.1 The Marginal Revenue Product of Labor and the Demand for Labor The marginal revenue product of labor equals the marginal product of labor multiplied by the price of the good. The marginal revenue product curve slopes downward because diminishing returns cause the marginal product of labor to decline as more workers are hired. A firm maximizes profits by hiring workers up to the point where the wage equals the marginal revenue product of labor. The marginal revenue product of labor curve is the firm’s demand curve for labor because it tells the firm the profit-maximizing quantity of workers to hire at each wage. For example, using the demand curve shown in this figure, if the wage is $600, the firm will hire 4 workers.

The marginal revenue product curve tells a firm how many workers it should hire at any wage rate. In other words, the marginal revenue product of labor curve is the demand curve for labor.

Solved Problem 17.1 Hiring Decisions by a Firm That Is a Price Maker We have assumed that Apple can sell as many iPhones as it wants to sell, without having to cut the price. Recall from Chapter 12 that this is the case for firms in perfectly competitive markets. These firms are price takers. Suppose instead that a firm has market power and is a price maker, so that to increase sales, it must reduce the price. Assume that Apple faces the situation shown in the following table. Fill in the blanks and then determine the profit-maximizing number of workers for Apple to hire. Briefly explain why hiring this number of workers is profit maximizing.

Solved Problem 17.1 Hiring Decisions by a Firm That Is a Price Maker Solving the Problem Step 1: Review the chapter material. Step 2: Fill in the blanks in the table. Step 3: Use the information in the table to determine the profit-maximizing quantity of workers to hire. Compare the marginal revenue product of labor with the wage. Hiring the third worker would reduce Apple’s profits by $160. Therefore, Apple will maximize profits by hiring 2 workers. Your Turn:For more practice, do related problem 1.6 at the end of this chapter. MyEconLab

The Market Demand Curve for Labor The market demand curve for labor is determined by adding up the quantity of labor demanded by each firm at each wage, holding constant all other variables that might affect the willingness of firms to hire workers. Factors That Shift the Market Demand Curve for Labor The five most important variables that cause the labor demand curve to shift are the following: 1. Increases in human capital. More educated workers are more productive, thereby increasing the demand for their services and causing the labor demand curve to shift to the right. Human capital The accumulated training and skills that workers possess. 2. Changes in technology. Better machinery and equipment increases the productivity of labor. This causes the labor demand curve to shift to the right over time.

Factors That Shift the Market Demand Curve for Labor 3. Changes in the price of the product. A higher price increases the marginal revenue product and shifts the labor demand curve to the right. A lower price shifts the labor demand curve to the left. 4.Changes in the quantity of other inputs. Over time, workers in the United States have had increasing amounts of other inputs available to them, and that has increased their productivity and caused the demand for labor to shift to the right. 5. Changes in the number of firms in the market. If new firms enter the market, the demand for labor will shift to the right. If firms exit the market, the demand for labor will shift to the left.

The Supply of Labor 17.2 LEARNING OBJECTIVE Explain how people choose the quantity of labor to supply.

Figure 17.2 Figure 17.3 The Labor Supply Curve A Backward-Bending Labor Supply Curve As the wage increases, the opportunity cost of leisure increases, causing individuals to supply a greater quantity of labor. Therefore, the labor supply curve is upward sloping. As the wage rises, a greater quantity of labor is usually supplied. As the wage climbs above a certain level, the individual is able to afford more leisure even though the opportunity cost of leisure is high. The result may be a smaller quantity of labor supplied.

At very high wage levels, the labor supply curve of an individual might be backward bending, so that higher wages actually result in a smaller quantity of labor supplied, To understand why, recall the definitions of the substitution effect and the income effect, which we introduced in Chapter 3. In the case of a wage change, the substitution effect refers to the fact that an increase in the wage raises the opportunity cost of leisure and causes a worker to devote more time to working and less time to leisure. The income effect refers to how an increase in the wage will increase a consumer’s purchasing power for any given number of hours worked. Because leisure is a normal good, a worker to devote less time to working and more time to leisure. So, the substitution effect of a wage increase causes a worker to supply a larger quantity of labor, but the income effect causes a worker to supply a smaller quantity of labor.

The Market Supply Curve of Labor The market supply curve of labor is determined by adding up the quantity of labor supplied by each worker at each wage, holding constant all other variables that might affect the willingness of workers to supply labor. Factors That Shift the Market Supply Curve of Labor 1. Increases in population. As the population grows, the supply curve of labor shifts to the right. 2. Changing demographics. Demographics refers to the composition of the population. An increase in the labor force and the working-age population, including women in the labor force, increases the labor force participation rate and the supply of labor. 3. Changing alternatives. Opportunities available in other labor markets, and generous unemployment benefits can cause changes in the supply of labor in particular markets.

Equilibrium in the Labor Market 17.3 LEARNING OBJECTIVE Explain how equilibrium wages are determined in labor markets.

Figure 17.4 Equilibrium in the Labor Market As in other markets, equilibrium in the labor market occurs where the demand curve for labor and the supply curve of labor intersect.

The Effect on Equilibrium Wages of a Shift in Labor Demand Figure 17.5 The Effect of an Increase in Labor Demand Increases in labor demand will cause the equilibrium wage and the equilibrium level of employment to rise: 1. If the productivity of workers rises, the marginal revenue product increases, causing the labor demand curve to shift to the right. 2. The equilibrium wage rises from W1to W.2. 3. The equilibrium level of employment rises from L1 to L2.

MakingtheConnection Will Your Future Income Depend on Which Courses You Take in College? In 2011, full-time workers ages 25 and over with a college degree earned more per week than other workers. According to the signaling hypothesis, employers see a college education as a signal that workers possess certain desirable characteristics: self-discipline, the ability to meet deadlines, and the ability to make a sustained effort. That signal may be more important than any skills the person may have learned in college. Your Turn:Test your understanding by doing related problem 3.3 at the end of this chapter. MyEconLab

The Effect on Equilibrium Wages of a Shift in Labor Supply Figure 17.6 The Effect of an Increase in Labor Supply Increases in labor supply will cause the equilibrium wage to fall but the equilibrium level of employment to rise: 1. As population increases, the labor supply curve shifts to the right. 2. The equilibrium wage falls from W1to W2. 3. The equilibrium level of employment increases from L1to L2.

Explaining Differences in Wages 17.4 LEARNING OBJECTIVE Use demand and supply analysis to explain how compensating differentials, discrimination, and labor unions cause wages to differ.

Figure 17.7 Baseball Players Are Paid More Than College Professors The marginal revenue product of baseball players is very high, and the supply of people with the ability to play Major League Baseball is low. The result is that the 750 Major League Baseball players receive an average wage of $3,260,000. The marginal revenue product of college professors is much lower, and the supply of people with the ability to be college professors is much higher. The result is that the 663,000 college professors in the United States receive an average wage of $81,000, far below the average wage of baseball players. Don’t Let This Happen to You Remember That Prices and Wages Are Determined at the Margin Wages, like prices, do not depend on total value but on marginal value. Like diamonds, if the supply is very small, the additional (or marginal) benefit consumers receive is high. Your Turn:Test your understanding by doing related problem 4.8 at the end of this chapter. MyEconLab

MakingtheConnection Technology and the Earnings of “Superstars” In most areas of sports and entertainment, the highest-paid performers—the “superstars”—now have much higher incomes relative to other members of their professions than was true a few decades ago. The increase in the relative incomes of superstars is mainly due to technological advances. With Blu-ray discs, DVDs, Internet streaming video, and pay-per-view cable, the value to movie studios of producing a hit movie has risen greatly. Not surprisingly, movie studios have also increased their willingness to pay large salaries to stars because they think these superstars will significantly raise the chances that a film will be successful. Today, when a hit movie starring Angelina Jolie is available on DVD or for downloading, millions of people will buy or rent it. Why does Angelina Jolie earn more today relative to the typical actor than stars did in the 1940s? Your Turn:Test your understanding by doing related problems 4.11 and 4.12 at the end of this chapter. MyEconLab

Compensating Differentials Compensating differentials Higher wages that compensate workers for unpleasant aspects of a job. Each worker decides on his or her willingness to assume risk and decides how much higher the wage must be to compensate for assuming more risk. One surprising implication of compensating differentials is that laws protecting the health and safety of workers may not make workers better off. Laws that improve safety in the riskier industry may reduce the compensating differential, and therefore worker wages relative to other industries. The psychological principle known as cognitive dissonance might cause workers to underestimate the true risk of their jobs. According to this principle, people prefer to think of themselves as intelligent and rational and tend to reject evidence that seems to contradict this image. Because working in a very hazardous job may seem irrational, workers in such jobs may refuse to believe that the jobs really are hazardous.

MakingtheConnection Are U.S. Firms Handicapped by Paying for Their Employees’ Health Insurance? When choosing among jobs, workers consider all aspects of the job, including total compensation. In the labor market, it would be more accurate to refer to the equilibrium compensation rather than the equilibrium wage. Did paying for employees’ health care contribute to Chrysler’s bankruptcy in 2009? At many firms in the United States, a significant portion of the compensation workers receive is in the form of employer payments for health insurance. Among the proposals by President Barack Obama to expand the government’s role in health care is that relieving U.S. firms from paying for health care would lower their costs relative to foreign competitors. But if labor markets determine equilibrium compensation, then a reduction in employer contributions for health insurance should lead to an offsetting increase in wages, leaving the total compensation paid by firms unaffected. Your Turn:Test your understanding by doing related problem 4.17 at the end of this chapter. MyEconLab

Discrimination Economic discrimination Paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic such as race or gender. Most economists believe that only a small amount of the gap between the wages of white males and the wages of other groups is due to discrimination. Instead, most of the gap is explained by three main factors: Differences in education Differences in experience Differing preferences for jobs

Differences in EducationSome of the difference between the incomes of whites and the incomes of blacks can be explained by differences in education. Differences in ExperienceWomen are much more likely than men to leave their jobs for a period of time after having a child. As a result, on average, women with children have less workforce experience than do men of the same age. Differing Preferences for JobsSignificant differences between the types of jobs held by women and men may be due in part to discrimination, but it is also likely to reflect differences in job preferences between men and women. . .

Solved Problem 17.4 Is Passing “Comparable Worth” Legislation a Good Way to Close the Gap between Men’s and Women’s Pay? As we have seen, either because of discrimination or differing preferences, certain jobs are filled primarily by men, and other jobs are filled primarily by women. On average, the “men’s jobs” have higher wages than the “women’s jobs.” Some observers have argued that many “men’s jobs” are more highly paid than “women’s jobs,” despite the jobs being comparable in terms of the education and skills required and the working conditions involved. These observers have argued that the earnings gap between men and women could be closed at least partially if the government required employers to pay the same wages for jobs that have comparable worth. Many economists are skeptical of these proposals because they believe allowing markets to determine wages results in a more efficient outcome. Suppose that electricians are currently being paid a market equilibrium wage of $800 per week, and dental assistants are being paid a market equilibrium wage of $500 per week. Comparable-worth legislation is passed, and a study finds that an electrician and a dental assistant have comparable jobs, so employers will now be required to pay workers in both jobs $650 per week. Analyze the effects of this requirement on the market for electricians and on the market for dental assistants. Be sure to use demand and supply graphs. Solving the Problem Step 1: Review the chapter material.

Solved Problem 17.4 Is Passing “Comparable Worth” Legislation a Good Way to Close the Gap between Men’s and Women’s Pay? Step 2: Draw the graphs. In panel (a), without comparable-worth legislation, the equilibrium wage for electricians is $800, and the equilibrium quantity of electricians hired is L1. Setting the wage for electricians below equilibrium at $650 reduces the quantity of labor supplied in this occupation from L1 to L2 but increases the quantity of labor demanded by employers from L1to L3. Theresult is a shortage of electricians equal to L3 – L2, as shown by the bracket in the graph. In panel (b), without comparable-worth legislation, the equilibrium wage for dental assistants is $500, and the equilibrium quantity of dental assistants hired is L1. Setting the wage for dental assistants above equilibrium at $650 increases the quantity of labor supplied in this occupation from L1to L3 butreduces the quantity of labor demanded by employers from L1to L2. The result is a surplus of dental assistants equal to L3 – L2, as shown by the bracketin the graph. Your Turn:For more practice, do related problems 4.18 and 4.19 at the end of this chapter. MyEconLab

The Difficulty of Measuring Discrimination When two people are paid different wages, discrimination may be the explanation. But differences in productivity or preferences may also be an explanation. MakingtheConnection Does Greg Have an Easier Time Finding a Job Than Jamal? Marianne Bertrand of the University of Chicago and Sendhil Mullainathan of MIT responded to help wanted ads by sending identical resumes, with the exception that half of the resumes were assigned an African-American–sounding name and half were assigned a white-sounding name. Their findings showed that, in fact, employers were 50 percent more likely to interview workers with white-sounding names than workers with African-American–sounding names. Bertrand and Mullainthan sent out more than 5,000 resumes to employers advertising for jobs in sales, clerical, and customer service. Their results were similar across these different types of jobs. Does having an African-American–sounding name make it more difficult to find a job? Your Turn:Test your understanding by doing related problems 4.20 at the end of this chapter. MyEconLab

Does It pay to Discriminate? Employers who discriminate pay an economic penalty. Figure 17.8 Discrimination and Wages Panel (b) shows that this increases the supply of pilots to “B” airlines and lowers the wage paid by these airlines from $1,100 to $900. All the women pilots will end up being employed at the nondiscriminating airlines and will be paid a lower wage than the men who are employed by the discriminating airlines. Initially, neither “A” airlines nor “B” airlines discriminates, and as a result, men and women pilots receive the same wage of $1,100 per week at both groups of airlines. “A” airlines then discriminates by firing all their women pilots. Panel (a) shows that this reduces the supply of pilots to “A” airlines and raises the wage paid by these airlines from $1,100 to $1,300.

Before the Civil Rights Act of 1964 was passed, many firms in the United States refused to hire black workers. Even though this practice had persisted for decades, nondiscriminating competitors did not drive these firms out of business. Why not? There were three important factors: 1. Worker discrimination. In some cases, white workers refused to work alongside black workers. 2. Customer discrimination. Some white consumers were unwilling to buy from companies in certain industries if they employed black workers. 3. Negative feedback loops. If discrimination makes it difficult for a member of a group to find employment in a particular occupation, his or her incentive to be trained to enter that occupation is reduced. Most economists agree that the market imposes an economic penalty on firms that discriminate, but because of the factors just discussed, it may take the market a very long time to eliminate discrimination entirely.

Labor Unions Labor union An organization of employees that has a legal right to bargain with employers about wages and working conditions. If a union is unable to reach an agreement with a company, it has the legal right to call a strike until a agreement has been reached. Figure 17.9 The United States is Less Unionized Than Most Other High-Income Countries The percentage of the labor force belonging to unions is lower in the United States than in most other high-income countries. Table 17.3 Union Workers Earn More Than Nonunion Workers

Personnel Economics 17.5 LEARNING OBJECTIVE Discuss the role personnel economics can play in helping firms deal with human resources issues.

Personnel economics The application of economic analysis to human resources issues. One issue personnel economics addresses is when workers should receive straight-time pay—a certain wage per hour or salary per week or month—and when they should receive commission or piece-rate pay—a wage based on how much output they produce. Figure 17.10 Paying Car Salespeople by Salary or by Commission This figure compares the compensation a car salesperson receives if she is on a straight salary of $800 per week or if she receives a commission of $200 for each car she sells. With a straight salary, she receives $800 per week, no matter how many cars she sells. This outcome is shown by the horizontal line in the figure. If she receives a commission of $200 per car, her compensation will increase with every car she sells. This outcome is shown by the upward-sloping line. If she sells fewer than 4 cars per week, she would be better off with the $800 salary. If she sells more than 4 cars per week, she would be better off with the $200-per-car commission.

MakingtheConnection Raising Pay, Productivity, and Profits at Safelite AutoGlass In the mid-1990s, Safelite shifted from paying its glass installers hourly wages to paying them on the basis of how many windows they installed. Under the new piece-rate system, the number of windows installed per worker jumped 44 percent. Half of this increase was due to increased productivity from workers who continued with the company and half was due to new hires being more productive than the workers they replaced who had left the company. Worker pay rose and Safelite’s profits also increased as the cost per window installed fell. Sociologists sometimes question whether worker productivity can be increased through the use of monetary incentives. The experience of Safelite AutoGlass provides a clear example of workers reacting favorably to the opportunity to increase output in exchange for higher compensation. A piece-rate system at Safelite AutoGlass led to increased worker wages and firm profits. Your Turn:Test your understanding by doing related problem 5.8 at the end of this chapter. MyEconLab

Other Considerations in Setting Compensation Systems Firms may choose a salary system for several good reasons: • Difficulty measuring output. Often it is difficult to attribute output to any particular worker. Projects may involve teams of workers whose individual contributions are difficult to distinguish. On assembly lines, the amount produced by each worker is determined by the speed of the line. Managers at many firms perform such a wide variety of tasks that measuring their output would be costly, if it could be done at all. • Concerns about quality. If workers are paid on the basis of the number of units produced, they may become less concerned about quality. • Worker dislike of risk. Piece-rate or commission systems of compensation increase the risk to workers because sometimes output declines for reasons not connected to the worker’s effort. Owners of firms are typically better able to bear risk than are workers. As a result, some firms may find that workers who would earn more under a commission system will prefer to receive a salary to reduce their risk.

The Markets for Capital and Natural Resources 17.6 LEARNING OBJECTIVE Show how equilibrium prices are determined in the markets for capital and natural resources.

The Market for Capital The marginal revenue product of capital is the change in the firm’s revenue as a result of employing one more unit of capital, such as a machine. Figure 17.11 Equilibrium in the Market for Capital The rental price of capital is determined by equilibrium in the market for capital. In equilibrium, the rental price of capital is equal to the marginal revenue product of capital.

The Market for Natural Resources The marginal revenue product of natural resources is the change in a firm’s revenue as a result of employing one more unit of natural resources, such as a barrel of oil. Although the total quantity of most natural resources is ultimately fixed, in many cases, the quantity supplied still responds to the price, during a particular period. In some cases, however, the quantity of a natural resource that will be supplied is fixed and will not change as the price changes. Economic rent (or pure rent) The price of a factor of production that is in fixed supply. In the case of a factor of production that is in fixed supply, the price of the factor is determined only by demand. For example, if a new highway diverts much of the traffic from a previously busy intersection, the demand for the land will decline, and the price of the land will fall, but the quantity of the land will not change.

Figure 17.12 Equilibrium in the Market for Natural Resources In panel (a), the supply curve of a natural resource is upward sloping. The price of the natural resource is determined by the interaction of demand and supply. In panel (b), the supply curve of the natural resource is a vertical line, indicating that the quantity supplied does not respond to changes in price. In this case, the price of the natural resource is determined only by demand. The price of a factor of production with a vertical supply curve is called an economic rent, or a pure rent.

Monopsony Monopsony The sole buyer of a factor of production. In Chapter 15, we analyzed the case of monopoly, where a firm is the sole seller of a good or service. The case in which the firm is the sole buyer of a factor of production is comparatively rare. For example, a firm may be the sole employer of labor in a particular location. A firm that has a monopsony in a factor market would employ a strategy similar to that of the monopoly: It would restrict the quantity of the factor demanded to force down the price of the factor and increase profits. A firm with a monopsony in a labor market will hire fewer workers and pay lower wages than would be the case in a competitive market. This results in a deadweight loss and a reduction in economic efficiency compared with a competitive market. In some cases, monopsony in labor markets is offset by worker membership in a labor union. A notable example of this is professional sports.

The Marginal Productivity Theory of Income Distribution Marginal productivity theory of income distribution The theory that the distribution of income is determined by the marginal productivity of the factors of production that individuals own. Marginal revenue product represents the value of a factor’s marginal contribution to producing goods and services. The more factors of production an individual owns and the more productive those factors are, the higher the individual’s income will be. The theory was developed by John Bates Clark, who taught at Columbia University in the late nineteenth and early twentieth centuries.

Economics in Your Life How Can You Convince Your Boss to Give You a Raise? At the beginning of the chapter, we asked you to imagine that you work at a local sandwich shop and that you plan to ask your manager for a raise. One way to show the manager your worth is to demonstrate how many dollars your work earns for the sandwich shop: your marginal revenue product. You could certainly suggest that as you have become better at your job and have gained new skills, you have become a more productive employee; but, more importantly, you could say that your productivity results in increased revenue for the sandwich shop. By showing how your employment contributes to higher revenue and profit, you may be able to convince your manager to give you a raise.

AN INSIDE LOOK AT POLICY Basketball Coaches’ Salaries:A March to Madness? The market for NCAA Division 1-A college basketball coaches.

Chapter Outline and Learning Objectives