Chapter Study Outline

3.1 The Neoclassical Labor-Demand Model

  • The neoclassical microeconomic framework asserts that
    • (a) The decision maker is a firm.
    • (b) The firm’s goal is to maximize its profits (Assumption 3.1).
    • (c) The constraints restricting the firm’s actions are
      • Technological
      • Informational
      • Policy
      • Market
    • The demand for labor is a derived demand, since the firm hires labor, buys capital, and purchases inputs with the derivative goal of maximizing profits.
  • Profits
    • Accounting profit: revenues less explicit costs
    • Economic profit: revenues less total costs
      • Total costs include both explicit costs and the implicit costs of not generating the profit available in the next best alternative.
      • Normal profit: the profit that the firm would accrue if its assets were used in the next best alternative
      • Supernormal profit: positive economic profit, generated when accounting profit exceeds normal profit.
    • A firm may generate positive accounting profit even as it generates negative economic profit.
  • In order to reach its profit-maximizing goal, the firm must answer:
    • (a) What actions are under the firm’s control?
    • (b) What actions are feasible?
    • (c) How does the firm determine the actions that maximize its profits?
      • Choice variables: the variables that the firm can control. In the short run, employment is a choice variable but plant size is not.
      • The firm will make marginal (i.e., small) changes in variables in order to gradually increase profits until it reaches the maximum level of profit at which further changes will lead to a zero or negative change.
        • MR: marginal revenue, or the revenue generated from selling one more unit of output, y
        • MC: marginal cost, or the cost of selling one more unit of output, y
        • The firm will increase or decrease units of output until MC = MR, at which point the firm will have maximized its profit.

3.2 The Constraints

  • Assumption 3.2: Technology: in economics, technology represents the state of knowledge that allows for the production of a set of goods and services from a given set of inputs.
    • The technological possibilities available to a firm are described by the two-input, three-dimensional production function y = F(K ,L), in which
      • y = homogeneous output
      • F = the production function
      • K = homogeneous capital
      • L = homogeneous labor
        • The homogeneity assumption implies that all workers, jobs, and types of capital are identical.
        • The two-input assumption and the homogeneity assumption provide a starting point for analysis.
      • Short run: The length of time that is too brief to allow the firm to adjust its capital stock, K, by installing new machines, constructing new buildings, and so on. However, the firm may adjust the employment level, L, in the short run.
      • Long run: The length of time over which the firm can adjust both K and L.
        • The length of the short and long runs varies among industries.
    • The production function y = F(K, L) is concave, which indicates that average input combinations produce more output than extreme combinations.
      • Production isoquant: a locus, such as y0, representing a single level of output that the firm may obtain by choosing multiple combinations of K and L. The term isoquant is derived from iso, which means “equal,” and quant, for “quantity.”
        • If either K = 0 or L = 0, the firm cannot produce any output.
    • The short-run production function: y = F(L, K0) = ƒ(L)
      • K0 represents the fixed, exogenous level of capital of the firm in the short run.
      • Since the firm may only change the amount of labor in this case, the short-run production function may be simplified to y = ƒ(L).
        • This two-dimensional production function is still concave.
        • The simplified production function is also known as the total product curve.
      • Increasing labor past will lead to a decrease in the level of output. Levels of labor beyond are usually omitted from discussion of the production function since they are economically irrelevant. It would not make sense for the firm to pay more for a level of labor that will decrease its output.
  • The marginal product of labor, MPL, is the change in output resulting from the employment of one additional labor hour, holding all other inputs constant, including K.
    • MPL is the slope of the short-run production function at a given point, defined as MPL = Δy / ΔL.
    • K = K0, since the capital stock is held constant.
    • ΔL = a small change in employment
    • Δy = the resulting change in output
    • The law of diminishing returns to labor states that the MPL eventually decreases with increases in L, implying that each additional worker hour contributes less to total output than the last one.
      • Thus the graph of output, y, against labor hours, L, exhibits a diminishing positive slope, while the graph of marginal output, MPL, against labor hours, L, exhibits a negative slope, even though MPL is always positive.
        • The diminishing nature of the MPL represents the technological limitations that arise when an increasing number of workers must work with a fixed stock of capital.
        • The decline does not represent differences in the quality of the labor hired, but rather, differences in the tasks assigned to that labor, which are decreasingly productive at the margin.
  • The marginal product of capital, MPK, is analogous to the marginal product of labor. The marginal product of capital represents the additional output resulting from an additional machine hour holding all other inputs constant. It is the slope of the production function, y = F(K, L0), in which L0 is a constant.
    • MPK = Δy / ΔK
    • L = L0, since labor is held constant in this alternative case
    • ΔK = a small change in capital
    • Δy = the resulting change in output
  • Assumption 3.3: The Information and Policy Environment
    • In this model, there is complete certainty. The firm knows the values of all the variables that affect its profits when it makes decisions.
      • This assumption allows the model to focus on the firm’s demand for labor.
    • This model assumes that the only functions of the government are to protect property rights and enforce private contracts, and it performs these tasks perfectly.
      • This assumption is unrealistic since there are myriad government regulations. In order to observe the effect of any regulation, though, it is first necessary to determine what the outcome would have been in its absence.
  • Markets: the firm acts in three different markets
    • Product market: where the firm sells its output to consumers, other firms, and the government at a price of p per unit. The product market influences the revenue (R) that the firm can generate.
      • Monopoly: occurs if the firm is the only seller in the product market
    • Labor market: where the firm hires labor at the hourly wage, W
    • Capital equipment market: where the firm leases capital at the hourly rental rate, R
      • Factor market: the labor and capital markets are known as factor markets since they sell the inputs necessary for production. The factor market influences the total costs, C, that the firm incurs.
      • Monopsony: occurs if the firm is the only buyer in a factor market
    • Perfect competition: occurs when buyers and sellers are price takers. They have no influence on the market price and they can purchase as much or as little as they want at that price.
      • Under perfect competition, MR = p, since the firm is a price taker and can sell every unit at p.
    • Imperfect competition: occurs if either a buyer or a seller has some price-setting power. A seller possesses monopoly power if it can influence the price, and a buyer possesses monopsony power if it can influence the price.
  • The product markets
    • MRPL: the marginal revenue product of labor, or the change in the firm’s revenue resulting from the employment of an additional labor hour holding all other productive inputs constant.
      • MRPL represents an indirect connection between revenues, R, and labor, L.
        • y = ƒ(L)
        • R = p ∙ y
        • L y R
        • MRPL = MR ∙ MPL
  • The factor markets
    • The firm’s total costs, C are the costs of hiring all the firm’s factors of production, such that C = R ∙ K + W ∙ L.=
      • R ∙ K represents a fixed cost. FC, since K is fixed in the short run.
      • W ∙ L represents a variable cost, VC, since the firm can adjust L.
    • MCL: the marginal cost of labor, defined as the change in total costs resulting from the employment of an additional labor hour holding K constant. Under perfect competition, MC L= W since each additional labor hour costs the same in the absence of monopsony power.
  • The firm’s manager will seek to hire the optimal level of labor, L*, which will occur when the condition MRPL = MCL is satisfied.

3.3 Perfect Competition and Monopoly Power

  • Model 3.1: The Short-Run Demand for Labor: Assumptions 3.1, 3.2, and 3.3 hold, and the firm can vary its employment level, L, but not its capital stock, K.
  • Perfect competition
    • The profit-maximizing demand for labor L* = MRPL = MCL
    • MR = p
    • MCL = W
    • MRPL = MR ∙ MPL
    • The profit-maximizing point on the labor demand curve occurs at the intersection of W and the negatively sloped MRPL=p∙MPL schedule.
      • The profit-maximizing choice of employment, L*, is governed by p MPL = W, since p ∙ MPL = MRPL = MCL = W.
      • Thus, in terms of the nominal wage, W, the marginal-revenue product schedule, with a slope of MRPL = p ∙ MPL, is a perfectly competitive firm’s short-run labor-demand curve.
      • In terms of the real wage, the perfectly competitive firm’s short-run labor demand curve is given by MPL = W / p = w, which is obtained by dividing the nominal demand curve by the product price, p.
        • The MPL depends only on the firm’s production technology.
        • The real wage W / p = w depends only on competitively determined prices.
        • The labor-demand curve is negatively sloped, representing both the way the firm will demand less labor due to an increase in w and the assumed diminishing marginal returns to labor.
        • If K and L are gross complements, an increase in K will raise the MPL for each level of L, increasing the firm’s demand for labor at each given value of the real wage, w.
  • Monopoly power
    • With monopoly power, the seller is able to influence its product’s prices. Under oligopoly the firm is also able to exert a lesser degree of influence over prices.
      • The principal economic effect of monopoly power is that MR will be less than p for the monopolist, since the monopolist can expand output and obtain $p from the sale of one additional unit, but in doing so it reduces the price of all other units, y, that it brings to market.
    • The monopolist’s profit-maximizing demand for labor satisfies the condition MR ∙MPL = W.
    • The negatively sloped MRPL = MR ∙ MPL is the monopolist’s short-run labor-demand curve.
      • The monopolist’s labor-demand schedule lies to the left of the competitive firm’s schedule, pMPL, since for the monopolist, MR < p. Thus the monopolist demands less labor than a competitive firm.
      • However, the presence of monopoly power leave the wage rate, W, unaffected.
    • Unlike the competitive firm, the monopolistic firm generally accrues supernormal profits, or economic rents.
      • With positive economic profit, the monopolistic firm may pay its workers more than then competitive wage rate and remain profitable.
      • This implies that there could be a positive link between the level of monopoly power of a firm and its wages or a positive link between the size of a firm and its wages.

3.4 Monopsony

  • Though a monopsonist is defined as a single buyer of labor, a firm may possess some monopsony power if it is able to use its wage to influence the supply of labor.
    • This may help explain why large firms generally pay more than smaller ones, why similar workers are paid different wages, why traits such as race and gender are systematically correlated with workers’ compensation levels, and why an increase in minimum wage may increase both the wage and the level of employment.
  • While the monopsonistic firm’s marginal price of labor is variable, the perfectly competitive firm experiences a constant marginal price of labor, which requires a few assumptions.
    • Assumption 3.4: Large Numbers: there are many other identical jobs that offer the same wage as the competitive firm.
    • Assumption 3.5: Zero Search Frictions: workers are fully informed about the locations and wages of other firms, and they can instantly switch employers.
    • Assumption 3.6: Zero Mobility Costs: workers can switch locations without cost.
      • Together, these assumptions allow for the perfectly elastic labor-supply schedule of the perfectly competitive firm.
      • If any of these violations are violated, the labor-supply schedule will resemble the upward-sloping curve of the firm with some monopsony power, in which increasing the level of labor bids up the cost of labor, W.
  • In the monopsonistic framework, the firm’s labor-supply schedule, S, can be interpreted as a wage requirement’s schedule W = W(L).
    • The optimal level of employment, Lms*, is still governed by the condition MRPL = MCL, but MCL > W.
    • Given Lms*, the optimal wage, Wms*, is determined from the wage-requirement’s schedule, W=W(L), such that Wms* = W(Lms*).
    • When the monopsonistic firm bids up the price of labor in the static framework, it must pay a greater wage to all workers, since it has only one opportunity to set its wage.
    • The bidding-up effect means that the labor-supply schedule is positively sloped.
  • The monopsonistic firm still faces a competitive product market.
    • The marginal revenue product of labor is still the negatively sloped MRPL = p ∙ MPL.
  • The monopsonistic firm’s optimal demand for labor is governed by MRPL = MCL at L = Lms* and Wms* = W(Lms*).
    • Note that the monopsonistic outcome does not occur at the intersection of MRPL = MCL.
      • MCL = W(L) + (ΔW/ΔL) ∙ L
      • L > W
      • W(L) is the indirect effect of increasing labor.
      • (ΔW/ΔL) ∙ L is the direct effect of increasing labor.
    • Yet the monopsonistic firm has no demand curve for labor. A demand curve describes demand for an item based on its given price, but in the monopsony framework, both L and W are endogenously determined—they are chosen by the firm.
  • Compared to perfect competition, the presence of monopsony power will reduce the wage and the level of employment below their competitive values.
    • The monopsonistic firm recognizes that it bids up the wage against itself as it expands employment and is therefore discouraged from marginally expanding employment.
  • A wage floor, (W0, can increase a monopsonistic firm’s wage offer and optimal employment level.
    • While the wage floor increases the monopsonistic firm’s total labor costs, W ∙ L, it can also reduce the marginal cost of labor.
    • If the wage floor is too high the monopsonistic firm will reduce its employment level as the marginal cost of labor increases.
    • If the wage floor is too low, it will have no effect on the firm’s behavior.
  • Structural monopsony: a firm’s monopsony power arises because the labor that is supplied to it increases with its wage offer, as in the case of universities hiring professors.
  • Collusive monopsony: a group of firms band together to form a cartel to generate monopsony power in the face of a largely competitive labor market, as in the case of Major League Baseball.