Survey of Economics Principles

Applications and Tools 5th Edition

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 10
The Labor Market,
Income, and Poverty
Chapter Summary
In this chapter, we switch to the market for one of the factors of production—labor. Here are the main points
of the chapter:
• In the labor market, workers supply labor hours and receive the wage rate, the price of labor.
Firms demand labor hours with which to produce products; the demand for labor is derived from
the demand for output.
• The individual firm’s demand for labor is a function of the marginal revenue product of labor, the
price of output times the marginal product of labor.
• Wages may differ across occupations due to supply restrictions, high training costs, undesirable
job features, or artificial barriers to entry; wages may also vary due to gender or racial
discrimination.
• The government sets federal minimum wages, which increase earnings of workers who stay
employed but decrease employment.
• Labor unions are groups of workers that organize to attempt to improve wages and working
conditions. Unions tend to increase wages, but this can cause a decline in employment. It is
possible that unions may increase labor productivity by reducing turnover. A labor union may
also increase market efficiency if there is a monopsony employer of labor.
• As information in labor markets is asymmetric, the mixed market price will be too low for hard
workers and tend to drive them out of the market.
• A company paying an efficiency wage, a higher wage than the market wage, may be able to
attract hard workers and thus increase productivity by more than the wage increase.

Here are the key questions that students should be able to answer by the end of the chapter. These questions
appear in the chapter opener of the main text and again near the Applications within the chapter:
1. When the wage increases, will the typical person work more hours or fewer hours?
2. Who benefits from the immigration of low-skilled workers?
3. What explains differences in wages?
4. How does racial discrimination affect the labor market?

142
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 Chapter 10: The Labor Market, Income, and Poverty 143

Approaching the Material

Most students have some form of work experience and they would be willing to share some of their
personal experiences while in the labor market. They may be very well informed about minimum wages
and about the role of education in future earnings. Tap into this knowledge but be sure to remind the
students about who is doing the demanding and who is doing the supplying in the labor market.

Chapter Outline
10.1 The Demand for Labor
1. The demand for labor is a derived demand, because it is derived from the demand for the
products produced by the workers.
a. If a company produces output, it needs labor to produce it.

 Teaching Tip
Ask the class how many of them currently have jobs or worked over the summer. Ask
them why they think their employer employed them? What did they do at work? What
did they produce? What was it worth? What did they earn?

Remind students of the following key principle:

KEY PRINCIPLE: MARGINAL PRINCIPLE

Increase the level of an activity as long as its marginal benefit exceeds its marginal costs. Choose the
level at which the marginal benefit equals the marginal costs.

A. Labor Demand by an Individual Firm in the Short Run

1. The individual firm wants to hire workers up to the point where the marginal benefits
(revenues) from the last worker equal the wage rate.
2. The marginal product of labor is the change in output from one additional unit of labor.
3. The marginal-revenue product of labor (MRP) is the extra revenue generated from
additional unit of labor;
a. MRP is equal to the price of the firm’s output times the marginal product of labor.
4. Because of diminishing returns, the marginal product curve is downward-sloping, and thus so
is the MRP curve (See Table 10.1 and Figure 10.1). Remind students that wage equals the
marginal cost.)

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS

Suppose that output is produced by with two or more inputs and we increase one input while holding the
other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a
decreasing rate.

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144 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

5. The MRP curve is the firm’s short-run demand for labor, which is a curve showing the
relationship between the wage and the quantity of labor demanded over the short run, when
the firm cannot change its production facility.
6. The curve is shifted by changes in the price of the final good and changes in the productivity
of workers.
7. A change in the price of output or a change in worker productivity will shift the firm’s
demand curve for labor. (See Figure 10.2. Remind students of the difference between a shift
of the curve and a movement along the curve.)
B. Market Demand for Labor in the Short Run
1. The market demand curve for labor is the summation of each firm’s individual demand
curves for labor.
C. Labor Demand in the Long Run
1. The long-run demand curve for labor shows the relationship between the wage and the
quantity of labor demanded over the long run, when the number of firms in the market can
change and each firm can modify their production facilities.
2. The long-run demand for labor is still negatively sloped, for two reasons:
a. The output effect, the change in the quantity of labor demanded resulting from a change
in the quantity of output produced. An increase in the wage will increase production costs
and, thus, decrease supply of the final product. The firm sells less output and thus
requires fewer inputs.
b. The input-substitution effect, the change in the quantity of labor demanded resulting from
an increase in the price of labor relative to the price of other inputs. An increase in the wage
rate causes firms to shift away from labor toward substitute inputs. (This also explains why
certain production processes, such as mining, furniture production, and accounting, are done
in capital-intensive ways in developed countries where capital is relatively cheap and in labor-
intensive ways in less-developed countries where labor is relatively cheap.)
D. Short-Run Versus Long-Run Demand:
1. The short-run demand for labor will be more inelastic than the long-run demand for labor
because firms are less flexible.

10.2 The Supply of Labor

 Teaching Tip
Tell the students that over the last one hundred years, real wages for men and women
have increased. During the same period, men decreased the average number of hours they
worked per week while women did the opposite. Use the substitution effect and the
income effect to explain the difference. Ask them if they think this difference by gender
will continue.

A. The Individual Labor-Supply Decision: How Many Hours?

1. Will an increase in the wage increase the number of hours of labor an individual supplies?
a. Substitution effect for leisure demand: The change in leisure time resulting from a
change in the wage (the price of leisure) relative to the price of other goods. An increase
in the wage is equivalent to an increase in the price of leisure. Thus, the worker may
substitute consumption of other goods for leisure, and work more.

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 Chapter 10: The Labor Market, Income, and Poverty 145

b. Income effect for leisure demand: The change in leisure time resulting from a change in
real income caused by a change in the wage. If leisure is a normal good, the increase in
real income from a wage increase will cause the worker to wish to consume more other
goods and more leisure. Thus, the worker may work less.
2. Thus, some workers may choose to work less, some may choose to work more, and some
may choose to work the same number of hours.
B. An Example of Income and Substitution Effects
1. There are three reasonable responses to a higher wage
a. Work fewer hours to earn the same overall income.
b. Work the same number of hours to get more income and the same amount of leisure.
c. Work more hours because leisure time is more expensive.
C. The Market Supply Curve for Labor
a. The market supply curve for labor is a curve showing the relationship between the
wage and the quantity of labor supplied. In Figure 10.3, it is positively sloped.
b. As the wage increases, the quantity of labor supplied is likely to increase for three
reasons, even if not all individual labor supply curves are upward-sloping.
i. Hours per worker will increase for some workers.
ii. Some workers will switch to this market from other fields.
iii. Some workers will migrate into this geographical area from other areas.

Review the key question from the chapter opener and its related Application:

Question 1: When the wage increases, will the typical person work more hours
or fewer hours?
APPLICATION 1: CABBIES RESPOND TO AN INCREASE IN THE WAGE

This application discusses how taxi drivers have a lot of flexibility in choosing their work hours and we
can readily observe their response to an increase in the wage. An increase in the taxi fare, which is
regulated by cities, represents an increase in the wage earned by taxi drivers. An increase in the regulated
fare (an increase in the wage rate) actually decreases the quantity of labor supplied.

10.3 Labor Market Equilibrium

1. A market equilibrium is a situation in which there is no pressure to change the price of a good or
service. In this case, it tells us the wage earned and how many hours are employed in a market.
A. Changes in Demand and Supply
1. A change in demand: If the demand for the final product increases, the demand for labor used
to produce it will increase, increasing wages and hours. (See Figure 10.4)
2. A change in supply: If the number of workers increases, supply will increase; decreasing
wages but increasing hours.

 Teaching Tip
Several occupations offer examples of wages adjusting to changes in market conditions.
Nurses and computer engineers are two occupations that students can relate to. (See
Figure 10.4) Depending on the class, you can also use labor markets (for doctors for
example) to explain how market equilibrium may follow a “cobweb” pattern. Workers
have to acquire education and training before they can supply labor.

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146 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

B. The Market Effects of the Minimum Wage

1. (See Figure 10.5. Remind students that the impact depends on the elasticity of demand for
labor.)
2. The minimum wage raises wages above equilibrium, moving the market up along the labor
demand curve.
3. There are trade-offs associated with the minimum wage:
a. Workers who do not lose their jobs gain from the higher wage.
b. Some workers lose their jobs and thus lose.
c. Consumers lose through the higher price of goods produced.

Review the key questions from the chapter opener and their related Applications:

Question 2: Who benefits from the immigration of low-skilled workers?

APPLICATION 2: TRADE-OFFS FROM IMMIGRATION

Immigrants generally compete with low-skill natives. A decrease in the wage for low-skilled workers is
the result of immigration of low-skilled workers. However, this benefits consumers in the form of a
decrease in prices and benefits firms in the form of decreased production cost. High-skilled workers also
gain at the expense of low-skilled workers.

10.4 Explaining Differences in Wages and Income

 Teaching Tip
Ask the students to explain the difference in wages between grammar school teachers and
sports professionals. Education? Training? Supply? Demand? Skills?

A. Why Do Wages Differ Across Occupations?

1. Wages vary across occupations.
2. Wages may be high if the supply of such workers is small relative to the demand.
3. The supply of workers may be small for any of the following reasons:
a. Few workers with the required skills
b. High training costs
c. Undesirable job features
d. Artificial barriers to entry
B. The Gender Pay Gap
1. Women, on average, earn 25% less than men. The gap is smaller is European nations, but
larger in Japan.
2. One reason is that women tend to have, on average, less experience and training, and thus
some of the wage difference reflects a productivity difference.
3. Another is occupational preferences; women may choose to enter only certain occupations
(perhaps due to past discrimination in other occupations), and thus the supply of workers in
those areas is relatively high and wages are consequently low.
4. Occupational discrimination may also contribute to the disparity of wages.
a. Employers may have a bias against hiring women for the high-paying jobs.
5. Wage discrimination: some employers may just pay women less. Studies on this subject are
mixed with some show wage discrimination.

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 Chapter 10: The Labor Market, Income, and Poverty 147

C. Racial Discrimination
1. On average African-American and Hispanic men and women earn less than their white
counterparts.
2. One reason is that minority works tend to have, on average, less experience and training, and
thus some of the wage difference reflects a productivity difference.
3. Part of the wage gap is caused by racial discrimination.
D. Why Do College Graduates Earn Higher Wages?
1. The typical college graduate earns 100% more than the average high school graduate, a
premium that has only increased over time.
2. There are two main explanations for the college premium:
a. The learning effect is the increase in a person’s wage resulting from the learning of skills
required for certain occupations. A college education provides some training and skills,
so graduates earn more based on productivity differences.
b. College also has a signaling effect; the information about a person’s work skills conveyed
by completing college. The completion of a college degree signals to a prospective
employer something about the skills of a worker even if college itself adds no skills.
3. Technology has increased the “college premium,” as firms in all industries require more and
more sophisticated machinery that require more skilled workers.

Review the key question from the chapter opener and its related Application:

Question 3: What explains differences in wages?

APPLICATION 3: THE BEAUTY PREMIUM

A study has shown that beautiful people earn about 5% more than average and the penalty for bad looks is
about 8%. Biologists explain that good looks are markers for underlying characteristics such as health
and intelligence which give people a slight advantage in the labor market Another possibility is that some
people just prefer to work with beautiful people.

10.5 The Distribution of Income

A. Income Distribution Facts
1. There are two relevant measures of income:
a. Market income
b. Disposable income = market income + government transfers 2 taxes
2. See Table 10.2 for the distribution of income in the U.S.
3. The percent of market income is computed with the following four steps.
a. Rank the nation’s households according to income.
b. Divide the households into five groups, or “quintiles.”
c. Compute each group’s income by adding up the income received by all the households in
the group.
d. Compute each group’s percentage of total income by dividing the group’s income by the
nation’s total income.
4. There are substantial differences:
a. Lowest fifth earns 1.48% of market income.
b. Highest fifth earns 53.44% of market income.
5. There are three key factors to explain the differences in the shares of market income of U.S.
households:
a. Differences in labor skills and effort.

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148 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

b. Luck and misfortune.

c. Discrimination.
6. Government transfer and tax policies help to reduce income inequality.
a. Note the changes in the top and bottom quintiles when disposable income is used instead
of market income.

 Teaching Tip
Ask the students how they feel about an inheritance tax? What would happen if parents
could not transfer any wealth to their children? What would the distribution of income
look like over time?

B. Recent Changes in the Distribution of Income

1. Between 1970 and 2005, the distribution of income changed rapidly. (See Table 10.3)
2. The demand for highly-skilled (i.e. educated) workers increased relative to the demand for
less-skilled workers.
3. There are two main reasons for this increased demand:
a. Advances in technology
b. An increase in international trade
C. Changes in the Top End of Income Distribution: 1920–2002
1. Figure 10.7 shows the changes in the top end of the income distribution.
2. The share for the top income earners plunged during World War II, leveled out in the postwar
period, experienced a long period of relative stability, and then increased starting in 1970.
3. Why?
a. During WWII, decreases were due to government wage controls that compressed wages
and increased taxes that lasted until the 1980s.
b. The share of income earned in the top shifted from investment earnings to wage earnings.
c. The increase since 1970 has been concentrated in the highest-wage workers.
d. The U.S. experience is the opposite of France’s since 1970. France has seen the share of
the top decile go down.

10.6 Poverty and Public Policy

A. Poverty Rates For Different Groups
1. A household with an income below the official poverty budget is considered poor. See Table
10.4 for the incidence of poverty among different groups.
2. The following are groups which experienced substantial variations in poverty rates:
a. Race
b. Type of Family
c. Age
B. Redistribution Programs for the Poor
1. A means tested program is a government spending program that provides assistance to
those whose income falls below a certain level.
2. See Table 10.5 for the levels of expenditures.
C. Welfare Reform and TANF (Temporary Aid to Needy Families)
1. The 1996 Personal Responsibility and Work Opportunity Act eliminated the entitlements of
poor families to receive cash and contained two basic welfare reforms:
a. Welfare recipients must participate in work activities.
b. There is a time limit for assistance.
2. Since the reform, the number of people receiving assistance has decreased dramatically.

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 Chapter 10: The Labor Market, Income, and Poverty 149

D. Welfare and Work Incentives

1. How does assistance affect the incentive to work?
a. The larger the base payment, the lower the incentive to work.
b. Benefits decline as income increases, lowering the incentive to work.

Review the key question from the chapter opener and its related Application:

Question 4: How does racial discrimination affect the labor market?

APPLICATION 4: LAKISHA WASHINGTON VERSUS EMILY WALSH

Two experiments demonstrate that racial discrimination still affects the labor market. In one experiment,
two different applicants were sent to interviews for low paying jobs. One applicant was a white male who
admits to serving 18 months in prison. The other applicant was an African American male with no
criminal background. The white applicant was called back 17% of the time, while the black man was
called back 14% of the time. In the second experiment, identical resumes with different names were sent
out. Those with “white sounding” names were called for interviews 50% more than those with “black
sounding” names.

Additional Applications to Use in Class

Question: How does the economy dictate college job prospects?

ADDITIONAL APPLICATION: THE 5 MOST MARKETABLE COLLEGE DEGREES OF

2009
Couch, Christina
"The 5 Most Marketable College Degrees of 2009"
MSNBC.com

Summary: Key Points in the Article

The college graduates of 2009 face a far different world than their counterparts from last year.
Unemployment levels continue to escalate, consumer confidence is at its lowest point since being
measured, and the recession is forecast to continue into 2010 before beginning recovery. In spite of the
grim picture there will be job increases in some fields such as health care and alternative energy.

The degrees predicted to have the brightest future include nursing ($52,000 average starting salary),
computer science ($60,000), engineering ($56,000), economics ($53,000), and education fields like math
and science (varies widely). All of these fields are predicted to have high demand for several years. In
addition, the demand for some business fields such as personal financial advisors is expected to grow by
40 percent in the next ten years.

Analyzing the News

Not all areas of the economy are doing poorly. For those just entering college, it is useful to know the
fields expected to be in demand. For those nearing graduation, they may have to consider retraining
before they even get their first job. The length and depth of the recession will no doubt dictate many
decisions.

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150 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

Thinking Critically Questions

1. What is human capital?
2. What types of human capital investments would help with the economic recovery?
3. Why would that have a longer term benefit for the economy?

Question: Why do some jobs pay more than others?

APPLICATION: AMERICA’S HIGHEST PAYING JOBS
Laura Morsch
“America’s Highest Paying Jobs”
Posted on MSN Careers
CareerBuilder.com

Summary: Key Points in the Article

According to U.S. government data, the majority of the top 20 highest paying careers occur in the medical
profession. The highest income jobs include surgeons who average $181,850 a year, pediatricians making
an average of $140,000 a year, and orthodontists who average $153,240 a year.

Among the non-medical professionals are airline pilots who average $134,090 a year and chief executive
officers who make an average of $140,880. Lawyers, computer information systems managers, and air
traffic controllers are also on the list of high paid professions. One common thread throughout the entire
list is that all require a minimum of a four year degree and most require graduate work. The information
for the list was obtained from the Bureau of Labor Statistics 2004 annual salary data which reports mean
annual salaries.

Analyzing the News

Note that most of the top paying jobs involve the highest level of training or educational attainment. The
more training required the fewer the number of people with that skill set. The opportunity costs for
training are high so the payoff needs to be large enough to induce people to incur the cost.

Thinking Critically Questions

1. Why do some jobs pay more than others?
2. What typical relationship do we see between wage rate and education?
3. What is the “learning effect?”

Question: How does population impact immigration?

APPLICATION: POPULATION GROWTH KEY TO IMMIGRATION CRISIS
Manuel Roig-Franzia
“Population Growth Key to Immigration Crisis”
Posted 4/17/2006 on MSNBC.com
The Washington Post

Summary: Key Points in the Article

Mexico’s poor economy drives much of the illegal migration of Mexican workers to the United States.
However, Mexico’s population boom also plays a large part in the equation. The country has failed to
create enough jobs to support the growing population of young people. Therefore, large numbers of the 38
million Mexicans between the ages of 15 and 34 are willing to migrate north in search of a better life.

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 Chapter 10: The Labor Market, Income, and Poverty 151

The passage of the North American Free Trade Agreement (NAFTA) was supposed to solve the problem
of illegal immigration by creating south of the border opportunities for Mexican nationals. However,
many of those jobs have failed to materialize. Exacerbating the problem is the fact that many Mexican
politicians feel little pressure to change the situation. The illegal migration to the U.S. solves the problem
for them and is costless.

While NAFTA initially created a number of jobs, competition from China pushed just as many overseas.
Between 2000 and 2004, 895 maquiladoras closed and many more downsized. While Mexico’s labor
force works cheap, China’s labor force works for even less. Most experts agree that the illegal migration
north will not change until Mexico begins creating enough jobs to employ its youth.

Graphing It Out

Analyzing the News

A population explosion among young labor age Mexican nationals further depresses wages in the
country’s soft economy as the graph indicates. An increase in the number of workers creates a rightward
shift in the supply curve. As wages fall, and more and more workers compete for the same jobs, more
Mexicans will choose to migrate to the U.S. in order to find a better life.

Thinking Critically Questions

1. Why does the Mexican government appear to favor illegal immigration?
2. Why has NAFTA not created as many jobs for Mexicans as anticipated?
3. How will the immigration problem ultimately be resolved?

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152 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

Solutions to End-of-Chapter Exercises

Chapter 10
SECTION 10.1: THE DEMAND FOR LABOR
1.1 marginal product, price of output
1.2 marginal revenue product, wage
1.3 marginal revenue product
1.4 down arrow, down arrow, up arrow, up arrow
1.5 increases, output , increases
1.6 steeper, few changes
1.7 Monthly income decreases from $200 ($2 × 100) to $180 ($3 × 60)
1.8 Incorrect because it ignores the output effect. An increase in the wage increases production cost
and the price of air travel. The resulting decrease in the quantity of airline travel demanded will
decrease the number of flights and pilots.

SECTION 10.2: THE SUPPLY OF LABOR

2.1 up arrow, down arrow, up arrow
2.2 up arrow, up arrow, down arrow
2.3 cannot, income, substitution, opposite
2.4 30, 20, negatively
2.5 True
2.6 negative
2.7 a. Initial income = $1,000 = $200 + $20 × 40 hours. New income with 40 hours of work =
$1,000 = $280 + $18 × 40.
b. There is no income effect because the initial choice of 40 hours generates the same income.
The substitution effect will reduce her hours worked.
2.8 Supply is more elastic for Portland because inter-city migration is less costly than international
migration.
2.9 The statement ignores the income effect of a change in the wage. A decrease in the tax rate
increases real income. An increase in income increases the demand for leisure and decreases the
supply of labor.
2.10 Different answers, depending on preferences.
2.11 a. less than 20% because the number of miles driven decreases.
b. Initial: $0.60 × 100 miles = $60. The percentage change in the mileage is –0.22 × 20% =
–4.4%. The new mileage is 95.6 miles, so the new income is $0.72 × 95.6 = $68.83

SECTION 10.3: LABOR MARKET EQUILIBRIUM

3.1 up arrow, down arrow
3.2 up arrow, up arrow
3.3 down arrow, up arrow
3.4 some restaurant workers, other restaurant workers, restaurant customers
3.5 negative. Data in the text indicates elasticity of –0.1.
3.6 less; decreases; low
3.7 highly skilled, prices, wages
3.8 a. 20, 22, 10
b. 70, 800, 700
c. The quantity of sweatshirts demanded at the higher price would increase. If the number
increased to 81, labor income would increase from $800 to $810.

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 Chapter 10: The Labor Market, Income, and Poverty 153

3.9 a. The equilibrium wage decreases by 4% = 12% /(2.0 + 1.0).

b. Cost of producing food and its price could decrease by 1%.
3.10

3.11 a. The wage is relatively low because supply is large relative to demand. On the supply side,
workers are willing to accept a relatively low wages because of working conditions.
b. The average quality increases. If the number of teachers hired doesn’t change, the tax liability
will increase. If the number of teachers hired decreases, but by a relatively small amount
because of inelastic demand, the tax liability will increase.

SECTION 10.4: EXPLAINING DIFFERENCES IN WAGES AND INCOME

4.1 demand, supply
4.2 high
4.3 lower
4.4 4
4.5 5, 8
4.6 learn through experience; earnings
4.7 a.

b. The equilibrium wage decreases by 3% = 12% / (3.0 + 1.0).

c. Output effect: The decrease in the wage decreases production cost and the output price, which
increases the quantity of output demanded and produced, causing the firm to hire more
workers. Substitution effect: The decrease in the wage relative to the price of other inputs
causes firm to substitute labor for other inputs.

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154 O'Sullivan/Sheffrin/Perez, Survey of Economics, 5e

4.8 a.

The increase in non-wage compensation will increase the supply of labor, shifting the supply
curve to the right and decreasing the equilibrium wage. So, workers get more in tips but less
in wage income. On the demand side, the increase in the net price of a meal will decrease the
quantity of meals demanded, shifting the demand curve to the left. This creates additional
downward pressure on wages.
b. Given the decrease in the equilibrium wage, the change in daily income will certainly be less
than $20. If the wage drops to $6, daily income would be unchanged at $110 = (1/5) $400 +
$6 × 5 hours.

SECTION 10.5: THE DISTRIBUTION OF INCOME

5.1 1.48, 4.68
5.2 high school graduates, college graduates, 100
5.3 up arrow, down arrow
5.4 up arrow, down arrow

SECTION 10.6: POVERTY AND PUBLIC POLICY

6.1 Hispanic, White, female-headed household, under 18 years
6.2 20, 10
6.3 20
6.4 False
6.5 50
6.6 a. Offer employment to the graduate of High School H.
b. Firms must believe the name provides (imperfect) information about whether an applicant fits
into one group or another, just like the information on high school affiliation.

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