Chapter 4 – Labor Market Equilibrium

4-1 Equilibrium in a single

competitive market
4-2 Competitive equilibrium
across labor markets
4-3 PA: Payroll taxes and subs.
4-4 PA: Payroll taxes vs
mandated benefits
4-8 The Cobweb Model
4-9 Non-competitive markets:
Monopsony
4-10 Non-competitive markets:
Monopoly

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Introduction
• Labor market equilibrium coordinates the desires of firms
and workers, determining the wage and employment
observed in the labor market.
• Market types:
o Competitive: many sellers & buyers
o Monopsony: one buyer of labor
o Monopoly: one seller of labor
• These market structures generate unique labor market
equilibria.

4-2
4-1Equilibrium in a Single Competitive
Labor Market
• Competitive equilibrium occurs when supply equals
demand, generating a competitive wage and
employment level.
• It is unlikely that the labor market is ever in an
equilibrium, since supply and demand are dynamic.
• The model suggests that the market is always moving
toward equilibrium.

4-3
 Efficiency
• Pareto efficiency exists when all possible gains from
trade have been exhausted.
• When the state of the world is (Pareto) Efficient, to
improve one person’s welfare necessarily requires
decreasing another person’s welfare.
• In policy applications, ask whether a change can make
any one better off without harming anyone else. If the
answer is yes, then the proposed change is said to be
“Pareto-improving”.

4-4
Equilibrium in a Competitive Labor
Market
Dollars  The labor market is in equilibrium when
supply equals demand; E* workers are
employed at a wage of w*.
S

 In equilibrium, all persons who are

P
looking for work at the going wage can
w * find a job (no involuntary
Q
unemployment).
 The triangle P gives the producer
D 0
surplus; the triangle Q gives the worker
surplus.
E * Employment  A competitive market maximizes the
gains from trade, or the sum P + Q.

4-5
 4-2 Competitive Equilibrium Across
Labor Markets
• If workers were mobile and entry and exit of workers
to the labor market was free, then there would be a
single wage paid to all workers.
• The allocation of workers to firms equating the wage
to the value of marginal product is also the
allocation that maximizes national income (this is
known as allocative efficiency).
• The “invisible hand” process: self-interested workers
and firms accomplish a social goal that no one had
in mind, i.e., allocative efficiency.

4-6
 Competitive Equilibrium in Two Labor
Markets Linked by Migration
Dollar Dollar
s SN s s SS SS

wN A

w* B w*

C wS
DN DS
Employment Employment
(a) The Northern Labor Market (b) The Southern Labor Market

Assumption: No/small mobility costs, Perfectly inelastic Ls (simplicity)

 Suppose the northern region (wN) has higher wages than south(wS).
 Southern workers want to move North, shifting the southern supply
curve to the left and the northern supply curve to the right.
 In the end, wages are equated across regions at w*.
 Surplus created in North from inflow of workers exceeds the surplus
destroyed in South (net surplus from migration is positive!) 4-7
 Efficiency Revisited
• The “single wage” property of a competitive equilibrium
has important implications for economic efficiency:

Recall that in a competitive equilibrium the wage equals the

value of marginal product of labor.
As firms and workers move to the region that provides the
best opportunities, they eliminate regional wage differentials.
Therefore, workers of given skills have the same value of
marginal product of labor in all markets.
• The allocation of workers to firms that equates the value of
marginal product across markets is also the sorting that
leads to an efficient allocation of labor resources.
4-8
 Wages and International
Trade: NAFTA
• NAFTA created a free trade zone in North America.
• Free trade reduces the income differential between the
United States and other countries in the zone, such as
Mexico.
• Total income of the countries in the trade zone is
maximized as a result of equalized economic
opportunities across the countries in the zone.

4-9
Wage Convergence Across
States 5.7
LA
GA
MENH
P erc ent A nnual W age Growth

5.5 VT
MS VA
KS
AR MD
FL MA
IA
5.3 CT MI
NC TN
SC AL DE
OK NJ
MN
PA
TX MO WI WV
NE OH
IN
5.1 RI IL CO WA
UT
NY
KY
AZ
ND MT CA
4.9
SD
NM
NV
4.7
ID
OR

WY
4.5
.9 1.1 1.3 1.5 1.7 1.9
Manufacturing Wage in 1950

Source: Olivier Jean Blanchard and Lawrence F. Katz, “Regional Evolutions,”

Brookings Papers on Economic Activity 1 (1992): 1-61.
4-10
 4-3 Payroll Taxes and Subsidies
• Payroll taxes assessed on employers increase total cost
of employment and lead to a downward, parallel shift in
the labor demand curve.

o The new demand curve shows a wedge between the

amount the firm must pay to hire a worker and the
amount that workers actually receive.

o Payroll taxes increase total costs of employment, so

these taxes reduce employment in the economy.

o Firms and workers share the cost of payroll taxes (tax

incidence), since the cost of hiring a worker rises and
the wage received by workers declines.
4-11
The Impact of a Payroll Tax Assessed
Dollars
on Firms
 A payroll tax of $1 assessed
S
on employers shifts down the
demand curve (from D0 to
w1 + 1
D1).
w0 A
 The payroll tax decreases
w1 B
the wage that workers
w0  1 receive from w0 to w1, and
D0
increases the cost of hiring a
D1
worker from w0 to w1 + 1
E1 E0 Employment (wedge!).

4-12
The Impact of a Payroll Tax put on
Firms with Inelastic Supply
Dollars
 A payroll tax assessed on the
S
firm is shifted completely to
workers when the labor
D 0 supply curve is perfectly
A inelastic.
w 0

 The wage is initially w0. The

$1 payroll tax shifts the
B
w –1
0
demand curve to D1, and the
D
wage falls to w0 – 1.
0

D 1

E 0
Employment

4-13
The Impact of a Payroll Tax Assessed on Workers
Dollars S
1

w +1 S 0
A payroll tax assessed
on workers shifts the
0

w
1 supply curve to the left
w 0
(from S0 to S1). The
payroll tax has the
w 1
1

same impact on the

equilibrium wage and
D
D
0

employment regardless
of who it is assessed
1

E E Employment
1 0

on.

4-14
 Payroll Subsidies (Read)
• An employment subsidy lowers the cost of hiring for
firms.

• This means payroll subsidies shift the demand curve for

labor to the right (up).

• Total employment will increase as the cost of hiring has

fallen.

4-15
 The Impact of an
Employment Subsidy (Read)
S

An employment subsidy of
w +1
0 $1 per worker hired shifts up
the labor demand curve,
w B
1
increasing employment. The
w
0 A wage that workers receive
rises from w0 to w1. The
w –1
1

D 1
wage that firms actually pay
D 0
falls from w0 to w1 – 1.
E
0 E 1 Employment

4-16
4.4 -The Impact of a Mandated Benefit
Dollar S0 Dollar S0
s s

w* + C P S1 P S1
w0 w0
w* + B
w1 Q

w* R
w0  C w* R
D0 D0
D1 D1
E1 E* E0 Employment E0 Employment

(a) Cost of mandate exceeds worker’s valuation (b) Cost of mandate equals worker’s valuation

4-17
In-class
4-1 Figure exercise:
4-9 discusses the changes to a labor market
equilibrium when the government mandates an employee benefit
for which the cost exceeds the worker’s valuation (panel a) and
for which the cost equals the worker’s valuation (panel b).

(a) Provide a similar graph to those in Figure 4-9 when the cost of
the benefit is less than the worker’s valuation, and discuss how
the equilibrium level of employment and wages have changed. Is
there deadweight loss associated with the mandated benefit?
 
(b) Why is the situation in which “a mandated benefit would cost
less than the worker’s valuation” less important for public policy
purposes than when “the cost of the mandated benefit exceeds
the worker’s valuation?”
2-18
Homework:
4-6 Consider a country with two regions (i.e. like Italy)

 An economy consists of two regions, the North and the South.

 The short-run elasticity of labor demand in each region is –0.5.
 Labor supply is perfectly inelastic within both regions.
 The labor market is initially in an economy-wide equilibrium,
with 600,000 people employed in the North and 400,000 in the
South at a wage of $15 per hour.
 Suddenly, 20,000 people immigrate from abroad and initially
settle in the South.
 They possess the same skills as the native residents and also
supply their labor inelastically.
2-19
Homework (continued):
(a) What will be the effect of this immigration on wages in each of the
regions in the short run (before any migration between the North
and the South occurs)?

(b) Suppose 1,000 native-born persons per year migrate from the
South to the North in response to every dollar differential in the
hourly wage between the two regions. What will be the ratio of
wages in the two regions after the first year native labor responds to
the entry of the immigrants?

(c) What will be the effect of this immigration on wages and

employment in each of the regions in the long run (after native
workers respond by moving across regions to take advantage of
whatever wage differentials may exist)? Assume labor demand does
not change in either region.

2-20
 4-5 The Cobweb Model
• Two assumptions of the cobweb model:
o Time is needed to produce skilled workers (Sluggish adjustment).
o Persons decide to become skilled workers by looking at conditions
in the labor market at the time they enter school (No forward
looking individuals!!).
• A “cobweb” pattern forms around the equilibrium.

• The cobweb pattern arises when people are misinformed.

• The model assumes naïve workers who do not form rational

expectations. Rational expectations are formed if workers correctly
perceive the future and understand the economic forces at work.

4-21
 The Cobweb Model in the Market
Dollars
for New Engineers
 The initial equilibrium wage in
the engineering market is w0.
S
The demand for engineers
shifts to D, and the wage will
w
eventually increase to w*.
1

w3

w *
 Because new engineers are not
w2
produced instantaneously and
w0
because students might mis-
judge future opportunities in the
market, a cobweb is created as
D
the market adjusts to the
increase in demand.
D  Critique: Valid under strict
assumptions
E 0
E
2 E *
E 1
Employment

4-22
4-10 Non-competitive Labor Market: Monopoly

• Firms that have monopoly power can influence the price

of the product (p) that they sell. (Output markets)
Important: Still consider the case where firm operates in
a competitive labor market (Input market)

• Monopolist faces a downward sloped market demand

curve for its output and an even lower downward sloped
marginal revenue curve.

• Consequently, MR<P

4-23
Marginal Revenue and Price - Monopoly
 Faces the entire market demand,
hence has absolute market power:
Can set the price of the output
 Consequently, has to lower the price
in order to be able to sell more.
Point A: p=$10 q=20 units TR=$200
Point B: p=$8 q=30 units TR=$240
MR= ΔTR/Δq = (240-200)/(30-20) =$4
Hence, at point B, p=$10 but MR=$4
 The marginal revenue from selling
an additional unit of output is less
than the price of the product
(MR<P).

4-24
The Output Decision of a Monopolist
 A monopolist faces a downward-
sloping demand curve for her output.
 The marginal revenue from selling
an additional unit of output is less
than the price of the product
(MR<P).
 Profit maximization occurs at point A
where the monopolist produces qM
units of output (where MR=MC) and
sells each unit of output at a price of
pM dollars (max price that consumers
are willing to pay at qM).
 Monopolist produces less (qM< q*)
but chargers more (pM> p*) than the
competitive firm. 4-25
 The Labor Demand Curve of a Monopolist
• How does hiring decision of monopolist differ?
Recall the (competitive) condition for profit maximization:
VMPL=MCL
VMPL=MRq * MPL and MCL=w (competitive input markets)

Similarly, monopolist keeps hiring additional workers until the

marginal revenue product of labor is equal to the wage rate:
MRq * MPL = w
Intuitively, as L increases, not only MPL decreases (law of
diminishing returns) but MRq decreases as well due to the
downward sloping demand curve & monopolist having to
reduce the price in order to sell the additional output. 4-26
The Labor Demand Curve of a Monopolist
 The marginal revenue
product (MRP) gives the
worker’s contribution to a
monopolist’s revenues (or
the worker’s marginal
product times marginal
revenue), and is less than
the worker’s value of
marginal product.
 Profit maximization occurs
at point A where the
monopolist hires fewer
workers (EM) than would
be hired in a competitive
market.
4-27
In-class
4-8. A Polly’sExercise:
Pet Store has a local monopoly on the grooming of dogs.
The daily inverse demand curve for pet grooming is:

 P = 20 – 0.1Q

where P is the price of each grooming and Q is the number of

groomings given each day.

This implies that Polly’s marginal revenue is:

MR = 20 – 0.2Q.

Each worker Polly hires can groom 20 dogs each day.

 How many workers should the firm hire each hour to maximize
profits?
 What is Polly’s labor demand curve as a function of w, the daily wage
that Polly takes as given?
2-28
 4-9 Noncompetitive Labor
Markets: Monopsony
• Monopsony market exists when a firm is the only buyer
of labor.
i.e. coal mine, university/hospital in a small town
• Monopsonists must increase wages to attract more
workers.
• Two types of monopsonist firms:
o Perfectly discriminating
o Nondiscriminating

4-29
Perfectly Discriminating Monopsonist
• Discriminating monopsonists are able to hire different
workers at different wages.

• To maximize firm surplus (profits), a perfectly

discriminating monopsonist “perfectly discriminates” by
paying each worker his or her reservation wage.

i.e. Analogous to perfect price discriminating monopolist

4-30
 The Hiring Decision of a Perfectly
Discriminating Monopsonist
Dollars
 A perfectly discriminating
S monopsonist faces an upward-
sloping labor supply curve and can
hire different workers at different
w *
A
wages.
w30
 Therefore the labor supply curve
VMP E
gives the marginal cost of hiring.
w10
 Profit maximization occurs at point A.
 The monopsonist hires the same
10 30 E
number of workers as a competitive
*
Employment

market, but each worker is paid his or

her reservation wage.
4-31
 Nondisriminating Monopsonist
• Must pay all workers the same wage, regardless of each
worker’s reservation wage.
• Must raise the wage of all workers when attempting to
attract more workers.

• Employs fewer workers than would be employed if the

market were competitive.

4-32
Wages and MCL Monopsonist
 A nondiscriminating monopsonist
pays the same wage to all workers.
Point A: w=$5 L=1 worker TCL=$5
Point B: w=$6 L=2 workers TCL=$12
MCL= ΔTC/ΔL = ($12-$5)/(2-1) =$7
Hence, at point B, w=$6 but MCL=$7
 The marginal cost of hiring exceeds
the wage, and the marginal cost
curve lies above the supply curve.

4-33
The Hiring Decision of a Nondiscriminating
Monopsonist
 The marginal cost of hiring
exceeds the wage, and the
marginal cost curve lies
above the supply curve.
 Profit maximization occurs at
point A; the monopsonist
hires EM workers and pays
them all a wage of wM.
 Monopsonist hires less
workers (underemployment)
and pays less than the
competitive case.
Question: Could competitive firms possess Monopsony power?
4-34
The Impact of the Minimum Wage on a
Nondiscriminating Monopsonist
Dollars
MC E
The minimum wage may
increase both wages and
S
employment when imposed
on a nondiscriminating
A
monopsonist.
A minimum wage set at wmin
w *
increases employment to
wmin
Ewmin.
wM
VMP E

Employment
EM Ewmin

4-35
Homework:
4-7. A firm faces perfectly elastic demand for its output at a price of $6
per unit of output. The firm, however, faces an upward-sloped labor
supply curve of
 E = 20w – 120
where E is the number of workers hired each hour and w is the hourly
wage rate. Thus, the firm faces an upward-sloped marginal cost of
labor curve of
MCE = 6 + 0.1E

Each hour of labor produces five units of output.

 How many workers should the firm hire each hour to maximize
profits?
 What wage will the firm pay?
 What are the firm’s hourly profits?

2-36