INTRODUCTION TO LABOUR ECONOMICS & 1.

2
PERSONNEL ECONOMICS

Labour economics can be simply defined as the economic analysis of labour market, where
as, business dictionary1 illustrates ‘labour market’ as “(usually) an informal market where
workers find paying work, employers find willing workers, and where wage rates are
determined”.

Definition and coverage of Labor Economics:

Labor economics encompasses many of the most important issues in economics. Most
people earn most of their income by selling their labor time. So labor economics deals with
the major source of personal income, what determines it, and why it may differ for different
individuals. It also deals with the allocation of the most important (in value terms) input
into the production process.

From a formal context, Labor economics is the field of economics, which examines
the organization, functioning, and outcomes of labor markets; the decisions of
prospective and present labor market participants; and the public policies, which
relate to the employment and payment of labor resources2.

Labor economics, as one of the major sub division of economics focuses its attention upon
the economics aspects of the problems, insecurities and institutional development
associated with labor.

Labor economics involves analyzing the determinants of the various dimensions of labor
supply and demand, which interact to determine wages, employment, and unemployment.

There are many dimensions to labor supply, including demographics (the effects of birth and
date rate), immigration and emigration policies (perhaps a brain drain), the labor force
participation decision, the hours of work decision (including overtime and moonlighting),
education and training (human capital decisions), and the disincentive effects of income
maintenance and unemployment insurance policies.

Labor demand focuses on how firms vary their demand for labor in response to changes in
the wage rate and other costs, including fringe benefits, legislatively imposed costs, and the
quasi-fixed costs associated with hiring and training workers.
Since labor demand is a derived demand (derived from the demand for the firm's output), it
is also influenced by factors such as free trade, global competition, and technological
change.

Labor market outcomes are also influenced by the type of market structure (the degree of
competition), union collective bargaining and various government laws (such as minimum
wage laws).

In recent time, labor economics has become increasingly empirical, with less emphasis on
theory. Among the areas growing or receiving the greatest attention are changes in the
wage structures (including occupational, industrial and regional wage differentials,

1
www.businessdictionary.com
2 Campbell R. McConnell, Stanley L. Brue, David MacPherson (2005), Contemporary Labor Economics

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 INTRODUCTION TO LABOUR ECONOMICS & 1.2
PERSONNEL ECONOMICS
union/non-union wage differentials, and male/female wage differentials, the issue of sex
discrimination in the labor market), the economics of education, social interactions and
personnel economics. The range of topics studied by labor economists today has broadened
far beyond those of traditional labor economics.

An overview of Labor Economics:

At first, it is valuable to have a brief overview of our field of study. The overview yields
insights as to how the subject matter of various issues of labor market relate to each
others. The most aspects of labor economics can be fitted under the headings of
‘microeconomics’ and ‘macroeconomics’. As we know, microeconomics is concerned with the
decisions of individual economic units and functioning of specific markets. On the other
hand, macroeconomics is concerned with the economy as a whole or with basic aggregates
which constitute the economy. Hence, the determination of wage rate and the level of
employment in a particular market – carpenters in Sylhet or retail clerk in Dhaka- are
clearly microeconomic matters. In contrast, the consideration of the average level of real
wages, the aggregate levels of employment and unemployment, and the overall price level
are issues of in macroeconomics. But some of the subject matters sometimes pertain to
both aspects of economics.
Labor economics has both microeconomic and macroeconomic dimensions of analysis.
Microeconomics focuses upon the determinations of labor supply and demand and the ways
in which supply and demand interact to determine wage rates and employment in various
labor markets. Labor unions, government, and discrimination all affect labor markets
through either supply or demand. Labor market determine the wage structure and the
personal distribution of earnings.

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 INTRODUCTION TO LABOUR ECONOMICS & 1.2
PERSONNEL ECONOMICS
They also generate incentives for labor mobility and migration. Macroeconomics stresses the
aggregative aspects of labor markets and , in particular, labor productivity, labor share of
national income, the overall level of employment, and the impact of wage upon the price
level. The above diagram3 shows the relationship among various contents of labor
economics.

Distinction of labor and scope of labor economics

Labor possess some distinguishable characteristics than those of other goods or services.
Labor services are rented, not sold
Suppliers of labor care about the way in which the labor is used
Labor productivity is affected by pay and working conditions
labor supply is affected by Non-monetary aspects (i.e., leisure time)

Distinction of Labor from other Goods and Services-

Aspect of Labor Explanations & Examples Consequences
1. Labor is a factor Unlike most goods which -income effects work in different ways
of production, not a households buy, labor is one of the for labor than other goods; “perverse”
final product. few goods they sell. responses like “backward-bending”
labor supply are more likely
-the demand for labor is a derived
demand, from the demand firms face
for their products
2. Like capital, The “stock” in this case is the -the stock must be produced and
labor is a flow of worker and the skills he/she maintained: education, training are
services attached possesses. The “flow” is the right needed.
to a stock of to use it for a period of time. -in most cases, delivery of the “flow”
“equipment”. requires physical presence: quality of
the work environment matters
3. Unlike capital, the -Slavery is prohibited -borrowing constraints may matter for
“stock” cannot be -For various reasons, people can’t human capital investment (education)
bought and sold. sell “shares” in -human capital investment is riskier
themselves, for example to than physical capital investment
finance education because it is non-diversifiable
4. Labor is a very -Workers are differentiated by type -a wide variety of prices and market
heterogeneous of skill, amount of skill, conditions for different labor services
commodity demographic characteristics. can coexist. This gives rise to a
distribution of earnings.
5. The quality of labor -workers may simply “shirk” -compensation and incentive systems
services being -poor management decisions may need to be designed appropriately
supplied is often hard not be apparent for years
to measure.

3
Campbell R. McConnell, Stanley L. Brue, David MacPherson (2005), Contemporary Labor Economics

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 INTRODUCTION TO LABOUR ECONOMICS & 1.2
PERSONNEL ECONOMICS
6. Sometimes the -employers’ associations, -use monopoly/monopsony and search
demanders and/or company towns, other monopsonists theory to study these markets
suppliers of labor -unions
have considerable -search costs, relationship-specific
monopoly power. skills and bilateral monopoly.
7. Labor markets are -income and payroll taxes -government policy has important
highly regulated; -income support programs effects on labor markets
the exchange of labor -workplace safety legislation
is both -immigration policy
highly taxed and -industrial relations legislation
subsidized -affirmative action, comparable
worth
All these distinguishable characteristics of labor and enormous importance of labor market
create the scope of accommodating the labor related economic discussion into a separate
sub-discipline of economics i.e, labor economics.

Importance of labor economics

Traditionally, labor economics is linked to the central core of economics by the theories of
labor market and wage determination. Most of the grown up population allocate a
substantial fraction of their time to the labor market. The labor market is one of the most
important mechanisms for transmitting the benefits of economic growth to different groups
in society.

We are studying the economics of the labor market, but what exactly is “the labor market”?
We can define it simply as all the buyers and sellers of labor services, and the institutions
those facilitate that buying and selling. But what are labor services? Labor services are the
direct input of human muscle and brainpower into production. Obviously this is very broadly
defined, and includes many occupations and tasks.

Labor services are distinct from the other major types of inputs, such as raw materials or
capital services. But we’ll see that this distinction is not so clear, for we will make use of the
idea that people invest in their own skills, which we will think of as human capital.

In fact the labor market consists of many markets. Labor markets differ in terms of location,
occupation, and skill. A labor market tends to be more like a single market to the extent
that there is a high degree of mobility within it. In this sense executives of Dhaka Bank and
Dutch-Bangla Bank are probably in the same labor market, but bankers and heart surgeons
are not really in the same labor market at all.

Keep in mind that not all work is bought and sold in labor markets. Much housework and
child care labor, for example, is performed by family members without pay. Such work is
not paid for in a market, but it may have important implications for people’s behavior in
markets for paid labor, because it constitutes an alternative use of a person’s time.

Labor economics is an important subject because unemployment is a problem that affects

the public most directly and severely. So the full employment (or reduced unemployment) is
one of the major goal of many modern governments.

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 INTRODUCTION TO LABOUR ECONOMICS & 1.2
PERSONNEL ECONOMICS
Introduction to personnel economics

Personnel economics (PE) is a relatively new but very active branch of labor economics.
The field has developed many ideas about workforce management and optimal personnel
policies. In addition, the field is highly empirical. This field has grown greatly in importance
in the past 20 years.

What is PE? A typical definition would describe it as the subfield of labor economics that
analyzes the design and effects of personnel policies. A broader definition would recognize
the strong complementation of PE with the economics of organizations. The economics of
organizations emphasizes the boundaries of the firm, organizational structure, and decision
making. These are closely related to personnel policies and involve similar economic trade-
offs. Moreover, they are all of relevance to an executive responsible for setting or
overseeing organizational policies.

Traditional labor economics focuses on overall labor markets, individual workers embedded
in those markets (not just in a single firm at a point in the career), or public policies. PE, by
contrast, more often than not takes the perspective of the employer. The typical objective in
PE is to understand the optimal design and effects of personnel policies. Instead of
analyzing wage levels for the whole economy, a personnel economist might think about how
to design a firm's salary system, and whether that system enables the firm to meet its
personnel objectives of recruitment, retention, training, or incentives. Empirical work in this
area often uses personnel records from a single firm or collects information on the design of
personnel policies across a set of firms, precisely because the interest is in how to design
those policies.

This focus is one of the primary reasons why the field of PE holds promise as an important
tool for research on organizational workforce policies. Much of that research is intended to
shed light on optimal employment policies for an organization.

PE became a strong subfield in its own right, somewhat separate from labor economics, with
two developments. The first was the adaptation of the economics of information and other
ideas from economic theory to applications inside organizations. As the theoretical ideas
advanced, economists (especially those employed in business schools) began applying the
ideas to understand the policies that a firm uses for its internal design and management of
personnel. Much of this early work was highly theoretical. However, the focus gradually
evolved to a more practical focus. A leader in this development was Edward Lazear, who is
generally credited as the primary founder of the field of PE. Two excellent examples of his
applied theoretical approach are his articles on salaries versus piece rate compensation
plans and tournaments. Both provided empirically testable predictions and practically
implementable prescriptions.

Personnel economists explore how the tools of sorting, signaling, and investments in human
capital might be used by a firm to improve the quality of its workforce. They have used the
idea of signaling to analyze how a firm can improve recruiting quality by structuring the job
offer so that workers who believe themselves to be a good fit are more likely to accept the
offer, while those who do not are more likely to reject the offer. Application of economic
ideas of sorting can be used to model how to structure a firm's promotion system.
Economists have studied the effects of various kinds of promotion systems on the incentives

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 INTRODUCTION TO LABOUR ECONOMICS & 1.2
PERSONNEL ECONOMICS
for workers to invest in firm-specific human capital (skills that are valuable to the current
employer) or general human capital (skills that are valuable to many employers).

PE developed as a subfield of labor economics over the last 20 years. While labor economics
tends to focus on labor markets--what happens across firms--PE focuses on what happens
within firms. PE has developed to such an extent that it has become recognized as an
important subfield distinct from labor economics. PE has a large group of researchers and
has been very successful in theoretical and empirical research. This line of study has many
practical applications for how firms structure themselves and manage their workforces.

PE holds great promise for contributing to research on organizational workforces. It is based

on the very strong foundation of classical microeconomic theory. This foundation has
enabled PE to develop a relatively comprehensive and rigorous way of thinking about
organizational design. This way of thinking does not replace traditional ways of studying
organizations. However, it does provide a systematic framework for studying many issues
using a consisted and tested toolbox. The PE approach is complementary to other
approaches but brings many new insights to the study of human resources.

The focus of PE is generally on the firm's perspective and on the design and effects of
personnel policies. Emphasis has usually been on practical theory that lends itself to
empirics. This approach is ideal for studying personnel records or similar data from
organizations and for helping such organizations figure out more effective methods of
managing their workforces. While public sector organizations have different objectives and
constraints than those of private sector organizations, most of the trade-offs that they face
are largely the same.

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