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Employment: The Supply and Demand for Labor
TEACHER: Hi, Student. Economists frequently classify inputs into three categories: labor, capital, and land. The problem of this simple classification is that each category contains an enormous variety of specific inputs.
When we speak of labor we must keep in mind that the category includes a great deal more than the organized labor. Since trade unions get a lot of press coverage, we may forget that in the US only about 20% of the labor force belongs to trade unions. This percentage is much higher in other parts of the world, of course. Student, will you give me a few examples of "labor" other than factory workers?
STUDENT: Sure. A secretary who works at Unilever, an account executive at Merrill Lynch, my dentist, a University professor like yourself... etc., etc., etc.
TEACHER: Correct. In advanced economies, about 2/3 of the people an economist would call "labor" are not factory or farm workers; they are the so called "white collar" workers –clerks, salespeople, managers- or service workers (such as waiters, hairdressers, or lawyers).
STUDENT: And it is common knowledge that people in these different types of labor earn very different wages.
TEACHER: Exactly. Average earnings vary considerably from one industry to another. For example, recent data in the US show that if we standardize the wages of construction workers at 100 points, workers in manufacturing averaged about 88 points, and workers in retail trade averaged only 38 points.
STUDENT: I am certain that we will investigate the reasons for these differences in wages, aren’t we?
TEACHER: Not only that, we will also be concerned with the total price of labor, which includes a great many forms of remuneration other than what we usually call wages.
As said, economists include as labor the services performed by professional people (such as lawyers, doctors, and professors) and self-employed businesspeople (such as electricians, mechanics, and barbers). The money such people earn is considered a particular sort of price of labor, even though these amounts are often called fees or salaries rather than wages.
STUDENT: I have been looking at some "time series", that is, wage earnings over time, and have seen very substantial differences in the same industries and for the same type of labor over a period of say, 10 years. In general, wages show important increments.
TEACHER: Naturally it is important to distinguish between money (nominal) wages and real wages. The real wage depends on the price level for goods and services as well as on the magnitude of the money wage. In many cases, if the time series is adjusted to inflation, real wages did not rise at all, an din many cases they fell.
The Equilibrium Wage And Employment Under Perfect Competition
Let’s begin by discussing the determinants of the price of labor under perfect competition. Student, please remind me about the basic assumption we made of the prices of products and inputs of firms under perfect competition.
STUDENT: No problem for me, Teacher. We assume that firms take the prices of their products, as well as the prices of all inputs, as given, and we assume that owners of inputs take input prices as given.
TEACHER: Correct. In this case, what determines how much labor an individual firm will hire at a specified wage rate? Once we answer this rhetorical question of mine, we can derive a firm's demand curve for labor. Incidentally, what do you think a demand curve for labor would be?
STUDENT: Not very differently from the firm’s demand for other inputs, a firm’s demand curve for labor is the relationship between the price of labor and the amount of labor utilized by the firm.
TEACHER: Exactly. It shows, for each price, the amount of labor that the firm will use. And it is reasonable to assume that a firm will utilize the profit-maximizing quantity of labor. Before we continue, let me remind you of a basic concept, the marginal product of labor. Or maybe you remember it?
STUDENT: I do. The marginal product of labor is the additional output resulting from an extra unit of labor. And before you ask me, I also remember the concept of diminishing marginal returns, Teacher.
TEACHER: Excellent. Let’s assume that we know the firm's production function and that labor is the only variable input. Given the production function, we can determine the marginal product of labor when various quantities are used. Student, what would you do if as a businessperson you notice that hiring an additional worker would yield you a revenue higher than the wage you’d have to pay to that worker?
STUDENT: For purely economic reasons I’d hire that worker; and I’d continue doing so until –as a result of diminishing returns- an additional worker would cost me more than the revenue that worker would yield.
TEACHER: I was going to ask you how many workers should the firm hire if it wants to maximize profit, but you have already answered the question; it should hire more workers as long as the extra workers result in at least as great an addition to revenues as they do to costs.
STUDENT: Let me put it in other words: profits are at maximum when the value of the marginal product of labor is equal to the price of labor.
TEACHER: What you just said shows me that you understand that the value of the marginal product of labor is the physical marginal product of labor multiplied by the product’s price. And I see you also realize that to maximize profit, the value of the marginal product of labor must be set equal to the price of labor. Can you tell me why?
STUDENT: Because if the value of the marginal product is greater than labor's price, the firm can increase its profit by increasing the quantity of labor used; while if the value of the marginal product is less than labor's price, the firm can increase its profit by reducing the quantity of labor used.
TEACHER: It is now a simple matter to derive the firm's demand curve for labor. We can also easily understand that many firms, not just one, are part of the labor market, and therefore the price of labor depends on the demands of all of these firms.
The market demand curve for labor shows the relationship between the price of labor and the total amount of labor demanded in the market.
STUDENT: Obviously it shows, for each price, the amount of labor that will be demanded in the entire market.
TEACHER: The market demand curve for labor, like any other input, is quite analogous to the market demand curve for a consumer good, which we discussed previously. But can you tell me at least one important difference between the demand for labor and the demand for a consumer good?
STUDENT:: Naturally, the demand for labor and other inputs is a derived demand, since inputs are demanded to produce other things, not for their own intrinsic value.
TEACHER: Yes, and this is the reason why the price elasticity of demand is higher for some inputs than for others. It is apparent that the higher the price elasticity of demand for the product the input helps produce, the higher the price elasticity of demand for the input.
STUDENT: Now that you have showed me the market demand for labor curve, it is not difficult to guess what comes next, is it?
TEACHER: That’s right, we will now discuss the market supply curve for labor. As we have seen, a product's price depends on its market supply curve as well as its market demand curve. This is also true for labor. Obviously, the market supply curve for labor is the relationship between the price of labor and the total amount of labor supplied in the market. Now let me ask you something, Student. Suppose your salary or wage is increased constantly. If you could decide how much overtime to work, would you work more or less overtime?
STUDENT: Well, at the beginning of that process I would probably work more overtime, since it would be more worthwhile for me to do the extra effort. But after a time, as I made more money working my regular hours, I’d work less overtime in order to have more leisure time.
STUDENT: A flawless description of how the market supply for labor behaves. When individuals supply labor, they are supplying something they themselves can use; the time that they do not work can be used for leisure activities.
Due to this, the market supply curve for labor, unlike the supply curve for inputs supplied by business firms, may be backward bending, particularly for the economy as a whole. That is, beyond some point, increases in price may result in smaller amounts of labor being supplied, as shown on the graph.
As you so well illustrated with your attitude in response to a constantly increased salary, the reason for the shape of this curve is that as the price of labor increases, workers become richer. And when they become richer, they want to have more leisure time. The consequence is that they want to work less.
STUDENT: But Teacher, is there no contradiction between the assumption that the supply curve of labor or other inputs to an individual firm is horizontal under perfect competition and the fact that the market supply curve for the input may not be horizontal?
TEACHER: We have to distinguish between the view of a single firm and what happens in the market as a whole. For example, an unlimited supply of unskilled labor may be available to any firm in a particular area at a given wage rate. But the total amount of unskilled labor supplied in this area may vary with changes in the wage rate due to variations of the aggregate demand for workers.
STUDENT: I see. This is similar to the sale of products. A particular firm under perfect competition rightly believes that it can sell all it wants at the existing price. However, the aggregate amount of the product sold in the entire market can be increased only by lowering the price.
TEACHER: Exactly, and by how much, depends on the price elasticity of the product. Now let’s turn to the equilibrium price and quantity of labor. The price of labor (or wages) under perfect competition is determined by supply and demand in essentially the same way that a product's price is.
The price of labor will be at equilibrium at the level where the quantity of labor demanded equals the quantity of labor supplied. As seen on the graph, the equilibrium amount of labor utilized is given by the intersection of the market supply and demand curves
Naturally, since labor is not an homogeneous input, these curves will be different for different types of workers in different geographical locations at a given point in time. Let’s compare the market for computer programmers and that for unskilled labor.
We can see in this graph that the demand curve for the services of programmers is to the right of the demand curve for unskilled labor. Also, the supply curve for the services of programmers is far to the left of the supply curve for unskilled labor.
I’ sure you can easily explain this difference, Student, can’t you?
STUDENT: The reason is that relatively few people are trained computer programmers, while practically everyone can do unskilled labor. In other words, programmers are much more scarce than unskilled laborers.
TEACHER: Exactly. It is then easy to understand why computer programmers receive a much higher wage rate than do unskilled laborers. The previous graph illustrates that the equilibrium price of labor for programmers is much higher than that for unskilled labor. This is a rather permanent situation, Student. Can you tell me why?
STUDENT: Well, the reason is that unskilled workers lack the training and often the ability to become computer programmers.
TEACHER: That’s right. Computer programmers and unskilled labor are examples of non-competing groups. Wage differentials can be expected to persist among these groups because people cannot move from the low-paid to the high-paid jobs.
But apart from this fact, there is an element that distorts our elegant analysis; and that element are the labor (trade) unions. You know what the labor unions are, don’t you, Student?
STUDENT: Of course. The unions are organizations of workers with power to collectively negotiate wages and other non-monetary compensations with employers.
TEACHER: Correct. The perfectly competitive model does not apply to these workers. Unions arose because workers recognized that acting together gave them more bargaining power. In short, unions increase wages.
Unions have considerable power, and we must include them in our analysis if we want our models of the labor market to be accurate.
From an economic theory point of view, the union may try to shift the supply curve of labor to the left, with the result that the price of labor will increase. How can the union reach this end? Unions have frequently forced employers to hire only union members, and then restricted union membership by high initiation fees, reduction in new membership, and other devices. In addition, unions have favored legislation to reduce immigration, shorten working hours, and limit the labor supply in other ways.
STUDENT: Reminds me of the very long apprenticeship periods common in the middle ages, which were also designed to restrict the supply of craftsmen allowed to practice a trade.
TEACHER: Same idea, indeed. Medieval trade unions were very powerful. To be allowed to be a shoemaker, an aspirant had to work for maybe 10 or more years as an apprentice in a union member’s shop, practically without pay.
The union may also try to shift the demand curve for labor upward and to the right. To cause this shift in the demand for labor, the union may resort to a practice known as featherbedding; it may try to restrict output per worker in order to increase the amount of labor required to do a certain job.
STUDENT: Yes, I remember that for decades the railroads had to man diesel engines with firemen (stokers), the workers needed to keep the fire going on obsolete steam locomotives.
TEACHER: There are many examples. The linotype operators at large newspapers violently resisted the use of computers; the prestigious US newspaper Herald Tribune closed due to this situation. And airlines were forced for years to man cockpits with navigators, a job made obsolete by satellite technology.
Unions also try to shift the demand curve by helping the employers compete against other industries or by encouraging the passing of legislation that protects the employers from foreign competition by instituting high tariffs.
STUDENT: And what can you tell me about collective bargaining?
TEACHER: Collective bargaining is the process of negotiation between the union and management over wages and working conditions. Representatives of the union and management meet to work out an agreement or contract. Obviously the main pressure element the union can use in these negotiations is the strike.
STUDENT: In many parts of the world minimum wages are fixed by federal governments or state governments. What effect do these have on the demand and supply of labor?
TEACHER: Minimum wages, as well as the many types of payroll taxes that exist, interfere with the market mechanism.
Minimum wages and payroll taxes shift the supply curve of labor to the left, obviously increasing the price of labor and displacing the equilibrium point to a lower level of employment. Basically minimum wages only affect the market for unskilled labor, while payroll taxes affect a much wider range of workers.
STUDENT: Defenders of the minimum wage argue that the level of poverty is decreased by these regulations. But of course, the contrary argument is that unemployment is higher than it would be in the absence of a minimum wage.
TEACHER: Depending on each country’s capacity to enforce labor regulations, in many cases minimum wages are not observed by employers. As workers in these cases become part of the underground economy, less taxes are collected. Also, because these workers do not contribute to social security schemes, they are not protected by them. And finally, employers that respect the regulations are subject to an unfair competition.
On the other hand, a reasonable level of social security contributions is justified, since if well run these schemes provide unemployment insurance as well as health and retirement benefits, which are valuable elements in a modern society.
Let me finish by saying that the tide is now working against all types of manipulation of the free demand and supply for labor. Globalization, the constantly increasing freedom of international trade, creates a pressure towards equalization of the price of labor all over the world. The differences in wages among countries are still very large; but the tendency towards a confluence is very clear. Real wages in the US and other developed countries have not grown for a long time, while real wages in a large number of developing countries from China to Korea to Mexico have been constantly increasing.
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