Labour Handout 2

Prepared By: Timkete A.
CHAPTER ONE: INTRODUCTION TO LABOUR ECONOMICS

The main problem that leads economics to be a distinct discipline is scarcity of productive
resources. Productive resources of any economic system like land, labor, finance, building
materials, and many others are limited and are bounded not to produce enough to satisfy material
needs of the society. The economic system is incapable of providing all the products and
services that individuals and societies would like to have. Consequently it arises for the society
to choice what to produce, how to produce and to whom to produce given the limited amount of
productive resources. In line with this, economics is concerned with the discovery of rules and
principles that indicate how such choices can be rationally and effectively rendered. It guides the
society to manage its scarce resources as effective as possible to achieve the maximum
fulfillment of its wants. Labour, of course, is one of society’s scarce productive resources and
this special field of economics centers upon the problem of its efficient utilization.
Labour economics is the economic analysis of how workers, firms and the government interact
in shaping the outcomes in the labour market, primarily employment and earnings. Some special
features of labor service and its great importance to an economy paved the way for the
development of Labor Economics, which is the study of the market for one particular commodity
in the economy, labor service. Labor economics is concerned with understanding the underlying
economic behaviour of individuals, households, and firms, decision makers in the market for
labor service, in the supply and demand for labor. In general, labour economics studies how
labour markets work.
1.1. Importance of Labour Economics

Labour is primarily an input in the production of goods. In this sense, it is by no means different
from potatoes in the production of French fries. However, there is no paper in Potato Economics.
The reason for this is that labour is a special production input.
i. Socioeconomic issues: One need simply glance at the newspaper headlines: Robots
replace, autoworkers, labour productivity plunges, more women enter labour force,
imports threaten jobs, unemployment reaches postwar peak, and so on. Many of the most
compelling socioeconomic issues of the day center upon the labour sector of our
economy.
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ii. Quantitative Importance: for many capitalistic economies of the world, the bulk of
national income is received not as capitalistic income (profit, rent, interest) but as wages.
The lion share of the national income flows to workers in the form of wages and salaries.
The primary source of income for the vast majority of households in the world is from
providing labor service to government and capitalists. Thus, quantitatively, labor is the
most important resource to an economy.
iii. Unique characteristics: The markets in which labor service are bought and sold embody
especial characteristics and peculiarities calling for separate study. A seller of commodity
like brick and banana does not care for what purpose the sold commodities will be used.
However, a seller of labor service, the labourer, cares about many things; type of job,
benefits, retirement, promotion, job security, training, place, field (profession) and a lot
about type and characteristics of the job. Non-monetary facets matters in labor market.
These unique needs of the seller for labor service arises a especial care to be considered
for labor market.
1.2. Peculiar Features of Labour and Labour Market

What is about labor as opposed to other factors of production has led to the development of labor
economics as a subject in its own right. Labor service cannot be sold like other commodities
rather it can only be rented; workers themselves cannot be bought and sold. Further, labor
service cannot be separated from workers, the condition under which such services are rented are
often as important as prices. Put differently, non-pecuniary factors such as work environment,
risk of injury, personality, perception of fair treatment and flexibility of work hours loom larger
in employment transactions than they do in markets for commodity. Therefore, the following are
the major peculiarities of labor that help to distinguish it from other factors of production.
i. The worker sells his work but retains capital in himself (Marshall, 1890): workers have
the ability to provide labor service by the virtue of the productive skills they possess.
However, while they can sell these services, they cannot sell the human being in which
they are embodied. Thus, workers and their skills, which can be regarded as human
capital, cannot be sold in the same way as physical capital.
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ii. Each seller of labor possesses subjective preferences about the use to which the labor is
put, the location of employment and working conditions. Workers will be greatly
influenced by perceived, non-pecuniary advantages and disadvantages of different sorts
of work. That is workers are interested in the total net advantages of a job.
iii. Employers may possess subjective preference about who wish to employ. Subjective
preference also affects the nature of an employer’s demand for labor. Employer
preference who to employ for what wage is influenced not only by productive capacity of
that worker but also by certain other characteristics like sex or race.
iv. The decisions to supply labor and consume goods are strongly interdependent: workers
who supply labor services are also consumers who purchase the fruits of labor effort.
Consumption of goods requires both money and time, the availability of which depends
on both the quantity and quality of labor which the worker supplies, and income derived
from that work. Consumption and labor supply decisions are thus simultaneously
determined.
v. The labor supply decisions of persons with in the same household are strongly
interdependent.
vi. The suppliers of labor often form independent labor unions, and take collective action in
pursuit of their goals (buyers of labor service can also band together). This formation of
labor unions and union of employers leads to create interface between labor economics
and industrial relations. In such cases, workers form a group that acts as a single seller-
monopoly and employer’s band together and acts as a single buyer monopsony; which we
call bilateral monopoly (i.e. a single buyer and a single seller of labor service). In such
cases, theories of bargaining become important.
vii. Psychological factors can have an important influence on the relation between employers
and employees. Concepts such as trust, loyalty, fairness, and motivation are very
important. New developments like implicit contract theory and efficiency wage theory
have recognized the relevance of these concepts.
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1.3. Interrelationship with other Fields of Economics

As many of other fields, labor economics mainly deals with application of microeconomics and
macroeconomics theories and models. Since it deals with wage determination, employment
relations, unemployment, and related policy issues, it is highly interrelated with sub fields of
economics. Since industrial economics is related with manpower and market for factors and
products, it has great relation with labor economics, especially in case of industrial labor
relations. Sub fields like development economics are concerned with income inequality and
poverty in which the later are focus of labor economics.
Labor economics is both an application of microeconomics theories and macroeconomics

theories. As an application of microeconomic theories, it deals with the role of individuals and
firms in labor market. It tries to examine the behaviour of these economic agents and how they
affect wage and quantity of employment supply at equilibrium. Work- leisure decision of
employees and employers decision to hire additional employee and the resulting wage and
employment level determined by the interaction of these two decision makers are by large the
application of microeconomic theories.
As an application of macroeconomic techniques, labor economics looks at the interaction

between labor market, goods market, the money market, and foreign trade market. It looks at
how these interactions influence macro variables such as employment level, participation rates,
aggregate income, and GDP. Moreover, it is related with monetary economics and international
economics.
1.4. Labour Economics in Historic Perspective

As a distinct sub discipline, labor economics is not a century old. Until its emergence as a
distinct sub discipline, it remained as “an integral part of the central tradition of theoretical
speculation in economics”. The central tradition of the theoretical speculation, in classical,
Marxian and neo-classical economics, focused on explaining how the market economy worked
and how prices of goods and services were determined and resources allocated on the process.
Labor theory of value for classicals/ Marxians and Theory of wages for neoclassicals were
central to the whole body of speculations in economics.
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As per Schumpeter's typology, Labor economics evolved through the interaction of Economic
Theory, Social Economics, and Political Economy. Labor economists more involved in the study
of Economic Theory have been more attracted by rigor (strictly, rigidity); those involved in
social economics have been more attracted by relevance; those in political economy were more
attracted by visions of reform. In general, Economic Theorists stand on the side of rigor while
Social Economists and Political Economists stand on the side of relevance.
The field of labor economics has long been recognized as an important area of study. However,
the content and subject matter of the field has changed rather dramatically in the past two
decades. 20 or 25 years ago, orientation of the field was mainly descriptive and historical. Its
emphasis would be on the history of the labor movement, a recitation of labor law and salient
court cases, the institutional structure of labor unions, and the scope and composition of
collective bargaining agreements. In short, the old study of labor was highly descriptive,
emphasizing historical developments, facts, institutions and legal considerations. A primary
reason for this approach was that the complexities of labor markets seemed to make them more
or less immune to economic analysis.
This state of affairs has changed significantly in recent decades. Economists have achieved
important analytical breakthroughs in studying labor markets and labor problems. As a result,
economic analysis has crowded out historical, institutional, legal, and anecdotal (subjective)
material. Labor economics increasingly has become applied micro and macro theory.
1.5. Unique Features of the Labour Market

(a) Long-term employment relationship
Unlike the commodity market, the relationship between the labor supplier and labor service
buyer is expected to continue for some time. The employment relationship has long-term nature.
The most important implications of the long term nature of employment relationship between
workers and firms is that it reduces the sensitivity of wages to changes in supply and demand
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and, thus, the ability of wages to clear the market. In commodity market, excess supply leads to a
drop in its prices as sellers underbid each other to attract a buyer, but in the labor market excess
supply of labor typically does not lead to a fall in money wage rates. While workers who are
unemployed might offer to work at a lower wages most firms would find it unprofitable to hire
them, because the costs of hiring and training as well as the effect on morale of existing workers
would far outweigh the saving in lower wages.
(b) Labor is embodied in the seller
Labor as a service to be exchanged in the market is embodied in a human being and is

inseparable from the person who is providing it. The worker supplying the labor service and the
firm buying the service must have a direct, personal relationship with each other. This and the
fact that human beings have definite preferences with respect to the conditions they work under,
causes the exchange in the labor market to be determined not only by the price of labor but by a
host of non economic factors that are largely absent in commodity markets. The importance of
these factors for labor economics is that the decisions of the workers whom to work for and the
decisions of firms whom to hire are based on a complex package of considerations, including not
only the wage but all non pecuniary advantages and disadvantages associated with the job or
worker.
(c) Heterogeneity of workers and jobs
The degree of differentiation in the characteristics of workers and jobs is frequently much greater
than that in goods market. Individual workers differ by age, race, gender, education, experience,
skills, and complex personality factors, such as motivation and congeniality, each individual
worker posing unique feature to firms; while workers also face similar diversity in choosing
employers as employers and jobs differ in the type and difficulty of the work, commuting
distance, fringe benefits, and equality of employee relations and wages.
(d) Multiplicity of markets
Labor market is segmented and fragmented and there is a multiplicity of individual sub markets
separated by geographic location, occupation, skill, and so on. Although many product markets
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are also less than national in scope, few are as fragmented as the labor market. Monopoly is
extremely rare in labor markets on the contrary monopsony is more common. Most of the labor
markets do not do justice in distribution of the proceeds.
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CHAPTER TWO: THEORY OF LABOUR SUPPLY

2.1. Labor supply, Concept and Measurement
The concept and measurement of labour supply is one of the problem areas of labour economics.
According to a recent survey, labour supply has become the most active area of labour
economics. This popularity is despite difficulties of concept and measurement.
2.1.1. Definition and Types of labour supply Theories

Labor supply is the term used to describe the human inputs into the production process. In other
words, it is the term used to describe the supply of factor of production, which results from the
activity of individuals. It is defined as the amount of labor, measured in person-hours, offered for
hire during a given period of time. Taking population as given, the quantity of labor supplied
depends on two main factors. First, there are the numbers engaged in or seeking paid
employment, which together make up the labor force or the supply of workers. Second, there is
the number of hours that each person is willing to supply once he or she is in the labor force –
the supply of hours.
The bulk of labor supply theory treats the individual (person) as the decision-making unit
attempting to choose between hours of work and leisure time to optimize personal utility.
However, while recognizing the importance of the individual there are a number of alternative
developments (theories) in the literature that focus on the individual within some larger
decision making unit; like the family and household the individual belongs. The economic
theories of labor supply can thus be categorized into four types.
i. The individual utility maximization model (the single person household)

ii. The ‘Chauvinistic model’, in which one partner (normally assumed to be the male)
decides on his labor supply independently of the female. The latter treats the male income
as if it were gives exogenously (i.e. as if it were property income), and then makes her
own labor supply decision.
iii. The ‘family utility/family budget constraint’ model. This model specifies some overall
family utility function containing the leisure of each family member. The earnings from
family members are pooled and the family maximized the overall utility function.
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iv. The ‘individual utility/family budget constraint’ models. In this case, individual have
their own goals, which they pursue within the various constraints set by the family unit.
2.1.2. Earnings of Labor

The actions of buyers and sellers in the labor market serve both to allocate and to set prices for
various kinds of labor. From a social perspective, these prices act as signals for incentives in the
allocation process, a process that relies primarily on individual and voluntary decisions. From the
worker’s point of view, the price of labor is important in determining income- and hence
purchasing power. Workers earn wage in return for the service they provide to firms and
employers.
Wage rate is the price of labor per working hour. The nominal wage is what workers get paid per
hour in current dollars; nominal wages are most useful in comparing the pay of various
workers at a given time. Real wages, nominal wages divided by some measure of prices
suggest how much can be purchased with workers nominal wages. Calculations of real wages are
especially useful in comparing purchasing power of worker’s earnings over a period of time
when both nominal wages and product prices are changing. The most widely used measure for
comparing the prices consumers face over several years is the consumer price index. It is
derived by determining what a fixed ‘bundle’ of consumer goods and services (including food,
housing, clothing, transportation, medical care, and entertainment) costs each year.
We often apply the term wages to payments received by workers who are paid on a salaried base.
The term wage refers to the payment for a unit of time, while earnings refer to wages multiplied
by the number of time units (typically hours) worked. Earnings depend on both wages and length
of time the employee works. Income- the total command over resources of a person or family
during some time period (usually a year)- includes both earnings and unearned income, which
includes dividends or interest received on investments and transfer payments received from the
government in the form of food stamps, welfare payments, unemployment compensation, and the
like.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = Wage rate (pay per unit of time) × units of time worked
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + Employee benefits (in kind or deferred payment)
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𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 + unearned income (Interest, dividend, gov’t transfer pay’t)
2.2. Labor Supply of the Economy

2.2.1. Labor Force, Participation Rates, and Hours of Work
Population of the country
Working age population Population below the working age
Labor force (currently active Population not currently active (Students, home makers, retired
population) (old aged pensioners), persons suffering from infirmity or
disablement)
Employed Unemployed
Without work, currently available for work,

Paid Self-employment and seeking work
employment
Shorthand notation of labor force:

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑜𝑢𝑡 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 = 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = (𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒 / 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛) × 100
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 = (𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 / 𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒) × 100
Labor force: refers to all those over 16 years of age who are employed, actively seeking work,
or expecting recall from a layoff. People who are not employed and are neither looking for work
nor waiting to be recalled from layoff by their employers are not counted as part of the labor
force. The total labor force thus consists of the employed and the unemployed.
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Employed: An individual is considered employed if they worked at a job for at least 1 hour
(self-employed are included) or worked at least 15 hours on a non-paid job (e.g. family farm).
This latter part of the definition is difficult to check, but generally, this excludes people working
at home for no pay (e.g. mothers or fathers taking care of their children).
Unemployed: An individual is considered unemployed if they are temporarily unemployed (e.g.

construction workers not working because of bad weather) or have been actively looking for
work in the past 4 weeks. Again, this definition is somewhat vague and arbitrary.
Out of the Labor Force: no one considered either employed or unemployed is counted as out of
the labor force. This generally includes students without jobs, homemakers, retirees, etc.
The labor force participation rate in the United States is about 75 percent for all men and 60
percent for all women. Similarly, the labor force participation rate in the Ethiopia is about 78
percent for all men and 68 percent for all women. The labor force participation rate varies
substantially with age.
Exercise 1:
1. Suppose that the adult population is 210 million, and there are 130 million who are
employed and 5 million who are unemployed. Calculate the unemployment rate and the
labor force participation rate.
2. Suppose the adult population of a city is 9,823,000 and there are 3,340,000 people who
are not in the labor force and 6,094,000 who are employed.
a. Calculate the number of adults who are in the labor force and the number of
adults who are unemployed.
b. Calculate the labor force participation rate and the unemployment rate.
Hours of work: ideally labor economists would want to measure all labor by a continuous
variable, such as the number of hours worked. For workers who are paid by the hour, this
information is readily available. For workers paid a salary or paid by the task, the number of
hours worked is not so easily measured. I am paid a salary and I would have difficulty reporting
on a survey the exact number of hours I worked last week.
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A related issue is that a continuous measure of hours may not be the appropriate measure of
labor supply. Few workers actually adjust their hours continuously in response to changes in
wage rates. If an employer offers a lower wage, workers may simply quit the job and move from
40 hours to 0 hours. Many economic models would assume a worker smoothly adjusts her hours
by moving from 40 hours to 34 hours, for example. Firms, too, have a related problem. Firms
generally hire workers not hours of labor. Because of fixed hiring and firing costs, firms may
also have difficulty smoothly adjusting their labor demand.
2.3. Reservation Wages and the Decision to Work

We define the reservation wage as the minimum wage rate that makes a worker indifferent
between working and not working. If she is offered a wage below her reservation wage, she
refuses to work. If she is offered a wage above her reservation wage, she works at that wage.
Call the reservation wage, w ∗ . If 𝑤 > w ∗ , then the worker works. If 𝑤 < w ∗ , the worker
works zero hours. If 𝑤 = w ∗ , the worker is just indifferent between working and not working.
2.4. Individual (Static) Labor Supply/ The Neoclassical Labor- Leisure Model
Labor supply decisions are diverse which differs from person to person, from culture to culture,
from country to country etc. Some individuals wants to have part-time work in addition to their
full-time work, others want to have only full-time work, while others still want to have only part-
time work. Some others, however, wants not to work at all. While some women with child to be
rear go to work regularly, others devote their full time to take care of their child. Some cultures
motivate societies to work as much as possible, while other cultures motivate more leisure.
In order to derive the static theory of labour supply, we use the standard tools of consumer
theory. Recall that consumer theory helps us understand how an individual (the consumer)
allocates a certain amount of money (income) to her expenditure on different goods. Her utility-
maximizing bundle will depend on the level of income and the relative prices of the different
goods. However, most people derive their income from working. People sell their work in the
market to buy consumption goods through labour earnings. If people want to consume more
goods, they will have to work more. However, people dislike working because this reduces their
free time. Work in this sense is a ‘bad’.
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The following is a simple model of individual labor supply decisions. In this model, individuals
choose how many hours to work in the labor market (H) and how many consumer goods to
purchase (C). Every hour the individual does not work is leisure time (L). Leisure is essentially
another good that the individual can purchase by not working. The total amount of time an
individual has is T. Therefore, the time constraint in the problem is 𝑇 = 𝐻 + 𝐿. For every
hour the individual works, she receives a wage (𝑤) per hour.
Individuals have preferences over the two goods, consumer goods (C) and leisure (L).
Preferences are indicated by a utility function: U(C, L). The utility function provides the number
of “utils” or satisfaction the individual receives from different combinations of C and L.
The price for consumer goods is p. The price of leisure is foregone wages (w). In other words,
the opportunity cost of leisure is the wage rate, that is, the cost of spending an hour entertainment
is what one could earn if one had spent that hour on working. This is a partial equilibrium model
and these prices are taken as given by the individual. The prices are exogenous.
The individual is assumed to have two sources of income: labor income from working (wH) and
non-labor income called V. V can be thought of as wealth the individual has accumulated (e.g.
savings or inheritance from a rich relative). The individual receives this non-labor income even if
she chooses not to work (𝐻 = 0).
2.4.1. Utility Maximization

A rational worker maximizes her utility that depends on leisure and consumption. The individual
maximizes her utility by choosing C and L subject to a budget constraint and a time constraint
(𝑇 = 𝐻 + 𝐿). The budget constraint is that total income (𝑤 𝑇 + 𝑉) must equal total
expenditures (𝐶 + 𝑤 𝐿 ) on consumer goods or on leisure:
𝐶 = 𝑤𝐻 + 𝑉
𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
𝐶 + 𝑤𝐿 = 𝑤 𝑇 + 𝑉
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The left-hand side is total expenditure on the two goods: consumption and leisure. The wage rate
W can be thought of the price of leisure. Why? It is the essentially the amount of money that the
worker has to give up if she wants to consume one extra unit of this good. The right-hand side is
the sum of unearned income (V) plus the income the worker would gain if she devoted all her
available time to work (𝑤𝑇). The sum of these two components is called full income (earned
income plus unearned income).
An indifference curve shows the various combinations of real income and leisure time that will
yield some specific level of utility or satisfaction to the individual. The IC slopes downward
because the additional utility associated more leisure must be offset by less income in order that
total utility remains unchanged. The convexity of the curve reflects a diminishing marginal rate
of substitution of leisure for income. The work leisure preference are different for each
individuals, some value leisure while others value work more. Those who value work more are
willing to give up leisure for small amount of income. Whereas those who value leisure more are
reluctant to give up leisure for small amount of income, if they do they need more amount of
income. The IC of workaholic is flatter, while that of leisure lover is steeper.
The individual’s optimal or utility-maximizing position can be determined by bringing together

the subjective preferences embodied in the indifference curve and the objective market
information contained in the budget constraint. Utility will maximize when budget constraint is
tangent to the highest attainable IC. At the tangency point, the individual is willing to substitute
leisure for income at precisely the same exchange rate, as the objective information of the labor
market requires. The optimal work-leisure position is achieved where MRS (the slope of the IC)
is equal to the wage rate (the slope of the budget line).
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V+wT
𝑪∗
𝐈𝐂
𝐇 ∗ /𝐋∗ T L
Mathematical Representation of the individual utility maximization problem
The maximization problem:

𝑀𝑎𝑥 𝑈(𝐶, 𝐿) 𝑠. 𝑡 𝐶 = 𝑤 𝐻 + 𝑉 𝑎𝑛𝑑 𝑇 = 𝐻 + 𝐿
Re-written in terms of leisure,
𝑀𝑎𝑥 𝑈(𝐶, 𝐿) 𝑠. 𝑡 𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
Writing the constrained optimization problem as a Lagrangian function,
Ω = 𝑈(𝐶, 𝐿) − λ (𝐶 + 𝑤𝐿 − 𝑤 𝑇 − 𝑉)
Where λ is the Lagrange multiplier. The first-order conditions are:
𝜕Ω
= 0 = 𝑀𝑈𝐶 − λ = 0
𝜕𝐶
𝜕Ω
= 0 = 𝑀𝑈𝐿 − λ𝑤 = 0
𝜕𝐿
𝜕Ω
= 0 = −𝐶 − 𝑤𝐿 + 𝑤 𝑇 + 𝑉 = 0
𝜕λ
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The last condition simply restates the budget constraint. If the equality holds, the optimal choice
of C and L must lie on the budget line. The ratio of the first two equations gives the familiar
condition that an internal solution to the neoclassical labor-leisure model requires that the ratio of
𝑀𝑈𝐿
marginal utilities = 𝑤.
𝑀𝑈𝐶
Numerical Example:
Given the utility function, 𝑀𝑎𝑥𝑈 = 𝑈(𝐶, 𝐿) = (𝐶 − 200)(𝐿 − 80)
s.t.
𝐶 = 1160 − 5𝐿
𝐿 ≤ 168
Find the optimal values of C and L.
Ω = (𝐶 − 200)(𝐿 − 80) − λ (𝐶 + 5𝐿 − 1160)
The first-order conditions are:
𝜕Ω
= 0 = 𝐿 − 80 − λ = 0
𝜕𝐶
𝜕Ω
= 0 = 𝐶 − 200 − 5λ = 0
𝜕𝐿
𝜕Ω
= 0 = −𝐶 − 5𝐿 + 1160 = 0
𝜕λ
𝐶−200
Combining (1) and (2): =5
𝐿−80
From this we can write 𝐶 = 5𝐿 − 200

Substituting in to (3) yields, 5𝐿 − 200 + 5𝐿 = 1160, after a little manipulation, we have
𝐿 = 136 ; 𝐶 = 480.
Since 𝐿 = 136 < 168, 𝐿 ≤ 168 is satisfied.
So far, we maximized the consumption and leisure by assuming the price for consumer goods is
constant. Now let us relax our assumption and incorporate the price for consumer goods in our
neoclassical labor-leisure model.
The maximization problem:

𝑀𝑎𝑥 𝑈(𝐶, 𝐿) 𝑠. 𝑡 𝑝𝐶 = 𝑤 𝐻 + 𝑉 𝑎𝑛𝑑 𝑇 = 𝐻 + 𝐿
16 | P a g e
Re-written in terms of leisure,

𝑀𝑎𝑥 𝑈(𝐶, 𝐿) 𝑠. 𝑡 𝑝𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
Writing the constrained optimization problem as a Lagrangian function,
Ω = 𝑈(𝐶, 𝐿) − λ (𝑝𝐶 + 𝑤𝐿 − 𝑤 𝑇 − 𝑉)
After a series of steps by using lagrangian function, neoclassical labor-leisure model becomes:
𝜕𝑈(𝐶, 𝐿)
𝜕𝐿 𝑤
=
𝜕𝑈(𝐶, 𝐿) 𝑝
𝜕𝐶
𝑀𝑈𝐿 𝑤
= = 𝑀𝑅𝑆
𝑀𝑈𝐶 𝑝
Where, 𝑀𝑈𝐿 is marginal utility of leisure and 𝑀𝑈𝐶 is marginal utility of consumption.
Example:
Given the utility function, 𝑀𝑎𝑥𝑈 = 𝑈(𝐶, 𝐿) = 𝐶𝐿

s.t. 𝑝𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
We can also rewrite the budget constraint as:
𝑤 (𝑇 − 𝐿) 𝑉
𝐶= +
𝑝 𝑝
i. Determine optimal leisure demand equation
ii. Determine optimal labor supply equation
iii. Calculate the optimal consumption of consumer goods
iv. Calculate the reservation wage and what will be the decision of the worker to work or not
to work?
Optimization problem as a Lagrangian function is:

Ω = 𝑈(𝐶, 𝐿) − λ (𝑝𝐶 + 𝑤𝐿 − 𝑤 𝑇 − 𝑉)
We noted above that this condition always holds:
𝑤
𝑀𝑅𝑆 =
𝑝
In this problem,
17 | P a g e
𝑀𝑈𝐿 𝐶
𝑀𝑅𝑆 = =
𝑀𝑈𝐶 𝐿
Since, 𝑀𝑈𝐿 is C and 𝑀𝑈𝐶 is L
Substituting,
𝐶 𝑤
=
𝐿 𝑝
Solve for C,
𝐿𝑤
𝐶=
𝑝
Now substitute this into the budget constraint:
𝐿𝑤 𝑤 (𝑇 − 𝐿) 𝑉
= +
𝑃 𝑝 𝑝
Simplify,
𝐿𝑤 = 𝑤(𝑇 − 𝐿) + 𝑉
𝑉
𝐿 =𝑇−𝐿+
𝑤
𝑉
2𝐿 = 𝑇 +
𝑤
Solve for optimal L to obtain optimal leisure demand equation,
𝟏 𝐕
𝐋∗ (𝐰, 𝐩, 𝐕, 𝐓) = (𝐓 + )
𝟐 𝐰
The above leisure demand equation shows that leisure consumption is decreasing in its price, w.
Leisure consumption is increasing in non-labor income V.
With an equation for optimal leisure demand, we can find everything else. Optimal labor
supply function is simply
1 V
H ∗ (w, p, V, T) = T − L∗ (w, p, V, T) = T − (T + )
2 w
Simplifying,
18 | P a g e
𝟏 𝟏𝐕
𝐇 ∗ (𝐰, 𝐩, 𝐕, 𝐓) = 𝐓−
𝟐 𝟐𝐰
If the person has no non-labor income (𝑉 = 0), she works exactly 1/2 of her time, regardless of
the wage. This is because of the particular utility function we assumed in which leisure and
consumer goods are equally valued.
We can also calculate the optimal consumption of consumer goods using the optimal leisure
decision.
𝑤 (𝑇 − 𝐿) 𝑉
𝐶= +
𝑝 𝑝
𝑉 𝑤 1 V
C∗ (w, p, V) = + [𝑇 − (T + )]
𝑝 𝑝 2 w
Simplifying,
𝟏𝑽 𝟏𝒘
𝐂 ∗ (𝐰, 𝐩, 𝐕) = + 𝑻
𝟐𝒑 𝟐 𝒑
You can also use
∗ (w,
L∗ 𝑤 𝑤 1 V 1𝑉 1𝑤
C p, V) = = [ (T + )] = + 𝑇
𝑝 𝑝 2 w 2𝑝 2𝑝
Consumption is increasing in non-labor income. Consumption is decreasing in the price of

consumer goods. Consumption is also increasing in the wage rate because of an income effect.
1
Note that if there is no non-labor income, the individual can buy 2 𝑤𝑇 worth of consumer goods.
The participation decision (reservation) wage is

1 1V
H ∗ (w, p, V, T) = T−
2 2w
Minimum wage rate is computed by making H ∗ = 0
1 1V
0= T−
2 2w
Simplifying,
𝐕
𝐰∗ =
𝐓
19 | P a g e
What is L∗ , H ∗ , and C∗ with p = 2, V = 8, w = 4?
To find the exact values of L∗ , H ∗ , and C∗ given these prices, simply substitute the prices into
each of our equations. Assume the individual has 𝑇 = 16 total hours each day to devote to
leisure or working (i.e. the individual sleeps for 8 hours each day).
1 V 1 8
L∗ = (T + ) = (16 + ) = 9
2 w 2 4
Check to make sure this is feasible: L∗ < 𝑇 and 9 < 16.
Note: It is possible that as non-labor income increases to very high numbers (e.g. V = 1000), the
optimal leisure decision will exceed the amount of time available: L∗ > 𝑇. This indicates that the
person is so wealthy that she chooses to never work.
Optimal labor supply is

1 1V 1 1 8
H∗ = T− = (16) − ( ) = 7
2 2w 2 2 4
Or we can use H ∗ = T − L∗ = 16 − 9 = 7
Optimal consumption of consumer goods is

1𝑉 1𝑤 1 8 1 4
C∗ = + 𝑇 = ( ) + ( ) 16 = 2 + 16 = 18
2𝑝 2𝑝 2 2 2 2
Finally, the reservation wage
V 8
w∗ = = = 0.5
T 16
Therefore, the worker must work (participate) because 𝒘 > 𝐰 ∗ = 𝟒 > 0. 𝟓
𝑀𝑈𝐿(𝑉,𝐿0 )
Reservation wage can also computed as w ∗ =
𝑀𝑈𝐶 (𝑉,𝐿0 )
Is the Time Constraint Satisfied?

This time constraint must hold at the values of labor supply and leisure demand we calculated.
T = H ∗ + L∗
20 | P a g e
16 = 7 + 9
Is the Budget Constraint Satisfied?
𝑝𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
2 ∗ 18 = 4 (16 − 9) + 8
36 = 36
Is the Tangency Condition Satisfied?

The tangency condition must hold at the values of L∗ and C∗ we calculated.
𝑤
𝑀𝑅𝑆 =
𝑝
In this problem,
𝑀𝑈𝐿 𝐶 ∗ 18
𝑀𝑅𝑆 = = =
𝑀𝑈𝐶 𝐿∗ 9
The price ratio is
𝑤 4
=
𝑝 2
Therefore, this condition holds:
18 4
=
9 2
2.5. Labor Supply Elasticity with Respect to Wages

Elasticity of labor supply measures the sensitivity of changes in hours supplied resulting from
change in wage rate. The labor supply elasticity with respect to wages is defined as
𝜕H ∗ (w, p, V) 𝑤
∈𝑙 =
𝜕𝑤 H∗
For example, in our example above
1 1V
H ∗ (w, p, V, T) = T−
2 2w
The first part is
𝜕H ∗ (w, p, V) 1 V
=
𝜕𝑤 2 w2
Substituting,
1 V 𝑤 1V 1
∈𝑙 = =
2 w2 H∗ 2 w H∗
21 | P a g e
This is the labor supply elasticity expressed as a function (at the point of optimal labor supply
H ∗ ). Given our prices and non-labor income, 𝑝 = 2, 𝑉 = 8, and 𝑤 = 4, and the optimal labor
supply value calculated above H ∗ = 7, the elasticity of labor supply is
1V 1 1 8 1 1
∈𝑙 = ∗
= ( )( ) =
2wH 2 4 7 7
At this point, labor supply is relatively inelastic.
2⁄ 1⁄
Exercise 2: Given the utility function, 𝑀𝑎𝑥𝑈 = 𝑈(𝐶, 𝐿) = 𝐶 3𝐿 3
s.t. 𝑝𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
i. Determine optimal leisure demand equation

ii. Determine optimal labor supply equation
iii. Calculate the optimal consumption of consumer goods
iv. What is L∗ , H ∗ , and C∗ with T = 24, p = 3, V = 30, w = 5?
v. Calculate the reservation wage and what will be the decision of the worker to work or not
to work?
vi. Calculate the labor supply elasticity and justify that labor supply is relatively inelastic
2.6. Labor Supply Curve

The labor supply curve is the sum of the individual labor supplies. The individual labor supply
curve exhibits the amount of hours an individual is willing to supply at different wage rates. If
each individual 𝑖 has different preferences ∑𝑁 ∗
𝑖=1 𝐻𝑖 (𝑤, 𝑝, 𝑉). If all individuals are identical, then
labor supply is simply: 𝑁 ∗ 𝐻𝑖∗ (𝑤, 𝑝, 𝑉).

2.6.1. The individual labor supply curve (Back-ward bending labor supply curve)
The individual labor supply curve is derived from the individual utility maximization problem
dealt above. Hence, we need to see response of the individual with wage rate changes and the
optimal allocation of leisure and work associated with each wage rates. The diagram below
depicts the individual’s optimal position at each wage rate and subsequently the diagrammatic
derivation of individual labor supply curve.
22 | P a g e
Wage rate (w)

Backward bending labor
supply curve
Wage-leisure curve
Hours of leisure (per day) Hours of work
Hours of work (per day)

Fig.2: Derivation of Labor Supply curve
To obtain the individual’s labor supply curve – the relationship between the supply of hours and
the hourly wage rate as their price – it is necessary to transpose the utility-maximizing positions
shown by the wage leisure curve on the wage rate versus supply of hours plane.
The labor supply curve gives an answer for the question that will an individual choose to work
more or fewer hours as the wage rate changes. As can be seen from the back ward bending labor
supply curve, for a specific person hours of work may for a time increase as wage rates rise, but
beyond some point, further wage increases may lead to fewer hours of labor being supplied.
23 | P a g e
2.7. The Effect of a Wage Rate Change on the Labor Supply

The effect of a wage rate change on labour supply (or hours of work) is decomposable into a
substitution and an income effect. A rise in wage has two separate effects. On the one hand, at
fixed labour supply, a rise in wage rate makes a worker better off. If leisure is a normal good, a
rise in wage rate therefore tends to increase leisure and the optimal number of hours of work
tends to fall. This is the income effect associated to a rise in market wage. However, if the wage
rate increases, the price of leisure increases relative to the price of consumption and therefore
workers will tend to substitute away from leisure (which has become more expensive) towards
consumption. This is the substitution effect. Through this channel an increase in the wage rate
tends to decrease the optimal hours of leisure and therefore to increase hours of work. Overall,
the net effect of a rise in the wage rate on the total number of hours is ambiguous, since this is
the combined effect of two forces acting in opposite directions.
2.7.1. Income Effect
The income effect refers to the change in the desired hours of work resulting form change in
come, holding the wage rate constant. The income effect of a wage increase is found by isolating
the increase in work hours resulting solely from the increase in potential income per hour of
work, as if the price of leisure (the wage rate) did not change. A wage rate increase means that a
larger money income is obtainable from a given number of hours of work. Part of this larger
income will be spent in goods and services to satisfy the material wants of the individual. In the
same way, if we assume leisure is a ‘normal good’ (a ‘good’ of which more is consumed as
income rise) then we can expect that a part of one be expanded income might be used to
“purchase” leisure. Consumers do not derive utility from goods alone, but from combination of
goods and nonmarket time (leisure). Workers/individuals purchase leisure in a unique way by
working fewer hours. This means that when wage rate rise, and leisure is a normal good, the
income effect results in a reduction in the desired number of hours of work.
2.7.2. Substitution Effect
The substitution effect indicates the change in the desired hours of work resulting from a change
in the wage rate, keeping income constant. An increase in the wage rate raises the ‘price’ or
opportunity cost of leisure. Because of higher wage rate, one must now forgo more income
(goods) for each hour of leisure consumed (not worked). The basic theory of consumer choice
implies that an individual will purchase less of any normal good when it becomes relatively more
24 | P a g e
expensive. The higher the price of leisure prompts one to consume less leisure or, in other words,
to work more. The substitution effect merely tell us that when wage rates rise and leisure become
more expensive, it is sensible to substitute work for leisure. For a wage increase, the substitution
effect results in the person desiring to work more hours.
2.7.3. Net Effect
The net effect of wage rate change on hours of work supplied depends on the relative magnitude
of both the income and substitution effects. If the substitution effect dominates the income effect,
the individual will choose to work more hours when the wage rate rises. But if the income effect
is larger than the substitution effect, a wage rate increase will prompt the individual to work
fewer hours.
The three most basic conclusions:
i. Higher non-labor income leads to lower labor supply through an income effect.
ii. If the substitution effect is larger than the income effect, higher wages increase labor
supply.
iii. If the income effect is larger than the substitution effect, higher wages decrease labor
supply.
2.7.4. Graphic Presentation of Income and Substitution effect

Substitution effect reflects the change in desired hours of work arising solely because an increase
in the wage rate alters the relative price of income and leisure. Therefore, to isolate the
substitution effect, we must control for the increase in income created by increasing in the wage
rate. Recall, too, that the income effect indicates the change in the hours of work occurring solely
because the higher wage rate means a larger income from any number of hours of work. In
portraying the income effect, we must hold constant the relative prices of income and leisure, the
wage rate.
25 | P a g e
𝐈𝐂𝟐
𝐰𝟐
𝐰′
𝐰𝟏
V
𝐈𝐂𝟏
𝐋=𝟎 𝐇𝟐 𝐇𝟏 𝐇𝟑 𝐇=𝟎
SE
NE
IE
From the income and substitution effect, we observe that, wage rate increase affects the worker:
by increasing monetary income and by increasing the relative price of leisure.
2⁄ 1⁄
Example: Given the utility function, 𝑀𝑎𝑥𝑈 = 𝑈(𝐶, 𝐿) = 𝐶 3𝐿 3
s.t. 𝐶 = 𝑤 (𝑇 − 𝐿) + 𝑉
T = 120, V = 300, w = 5
Show the magnitude of substitution effect, income effect, and net effect when the wage rate rise
to 10 Birr.
26 | P a g e
𝐈𝐂𝟐
𝐰𝟐 B
C
𝐰′
𝐰𝟏 A
V
𝐈𝐂𝟏
𝐋=𝟎 𝐇𝟐 = 𝟕𝟎 𝐇𝟏 = 𝟔𝟎 𝐇𝟑 = 𝟑𝟎 𝐇=𝟎
From exercise 2 we have the optimal labor supply function

2 1V
H ∗ (w, p, V, T) = T−
3 3w
Substituting,
2 1V 2 1 300
H1∗ = T− = (120) − ( ) = 60
3 3w 3 3 5
Substituting,
𝐶 1 = 𝑤 (𝑇 − 𝐿) + 𝑉
𝐶 1 = 𝑤 H1∗ + 𝑉 = 5(60) + 300 = 600
Now what happen to the optimal labor supply if the wage rate increases to 10.
The new optimal labor supply becomes
2 1V 2 1 300
H2∗ = T − = (120) − ( ) = 70
3 3w 3 3 10
Substituting,
27 | P a g e
𝐶 2 = 𝑤 (𝑇 − 𝐿) + 𝑉
𝐶 2 = 𝑤 H2∗ + 𝑉 = 10(70) + 300 = 1000
To get the value of optimal labor supply (H3∗ ), use the imaginary line.
Now let us compute the number of hour that an individual would be required to make the
individual just as well off (that is, attain the same total utility).
𝐶 1 = 𝑤 H3∗ + 𝑉
600 = 10 H3∗ + 300
10 H3∗ = 300
H3∗ = 30
What is the change in V?
Let us define 𝐶 ′ = 𝐶 2 − 𝐶 1
𝐶 ′ = 𝑤 H3∗ + 𝑉
Since the change in 𝑤 is constant in the case of income effect (𝑤 = 0)
𝐶 ′ = 0 (𝐻) + 𝑉 = 𝑉
𝑉 = 𝐶 2 − 𝐶 1 = 1000 − 600 = 400
𝐶 ′ = 𝑤 H3∗ + 𝑉
𝐶 ′ = 5 (30) + 400 = 550
𝑆𝐸 = H2∗ − H3∗ = 70 − 30 = 40
𝐼𝐸 = H3∗ − H1∗ = 30 − 60 = −30
𝑁𝐸 = 𝑆𝐸 + 𝐼𝐸 = 40 + (−30) = 10
Therefore, the substitution effect is larger than the income effect, which implies higher wages
increase labor supply.
Exercise 3:
1. Many empirical studies have confirmed that the response of both men and women to
changes in wage rate is different.
a. Who is much sensitive to wage changes?
b. Why labor supply responses of males and females to wage changes are different?
c. Identify which effect (substitution or income) substantially dominate for female
and male workers when wage rate rises.
28 | P a g e
2.8. The Effect of Non -wage Rate (unearned) Incomes on Hours of Work
So far, we have looked at changes in the wage rate, which manifested themselves in changes in
the slope of the budget constraint and changes in tastes, which were reflected in changes in the
slope of the indifference curves, but we have not yet look at changes in unearned income. A
change in unearned income at a given wage rate displaces the labour supply curve. A rise
displaces it to the left and a fall displaces it to the right provided that leisure is a normal good.
Therefore, a rise in unearned income leads unambiguously to reduction in hours worked,
provided leisure is a normal good.
2.9. The Effect of a Standard Workday on Labor Supply

In the above discussion, we implicitly assumed that workers can individually determine the
number of hours they work. However, this is not the case; rather there is a ‘standard’ workday
set by legislations, like in our case 8hrs per day (40 hrs per week). It is a common practice in
many countries to set legal limitations for hours of work, and the imposition of such laws
restricts the income leisure choice of individuals. Some may find the eight hours workday a bit
long and feel over employed, while other individuals in similar circumstances find themselves
underemployed.
𝐼𝐴3
W
𝐼𝐴2 𝐔𝐀
E 𝐼𝐵3
𝐼𝐴1
𝐔𝐁
𝐼𝐵2
𝐼𝐵1
𝐈𝐂𝟏
𝐋=𝟎 𝐇𝐀 𝐃 𝐇𝐁
𝐇=𝟎
29 | P a g e
Person B, whose income leisure indifference map is shown by the broken lines to the right of the
diagram, would be in equilibrium at UB, given the indifference set and the wage line. At UB
person B is placed on the highest indifference curve 𝐼𝐵3, would have worked 𝐻𝐵 hours and
enjoyed (𝐻 −𝐻𝐵 ) hours of leisure time. However, the choice he can make is either to work the
standard workday of D hours or none at all. If B chose not to work, he will be located at V (a
corner solution) and on a lower indifference curve 𝐼𝐵1 than be on the higher indifference curve
𝐼𝐵2, which he could do. If he chose to work, he would be at E where the slope of the indifference
curve is greater than the market wage (slope of the budget line). Obviously, his rational choice
would be to work the standard workday of D hours, even though he feels “over employed” as a
result.
On the other hand, person A whose indifference map is shown by the continuous curves to the
left of the diagram and facing the same budget line as B, will be in equilibrium at 𝑈𝐴 working 𝐻𝐴
hours and enjoying a leisure time of (𝐻−𝐻𝐴 ) hours, if he was not constrained by the standard
workday rule. If the standard workday of D hours is applied, he would be located at E on the
lower indifference curve 𝐼𝐴2 than 𝐼𝐴3 , his optimal choice. However, at E the slope of the
indifference curve is less than slope of the budget line and he would feel “underemployed”.
A standard workday legislation thus causes the underemployment of some workers (A in the
above example) and the over employment of others (person B). Those who feel they are over
employed tend to compensate themselves for the loss of leisure by going slow on their work,
deteriorating the quality of production, increased absenteeism, etc. Those that feel
underemployed (as a result of the workday legislation), tend to look for part-time or over-time
work to earn complementary incomes.
2.10. The Effect of Premium Wages and Straight-Time Equivalents on Labor Supply
The analysis so far has been confined to the case where the wage rate facing the worker remains
constant regardless of the number of hours worked. In practice, it is usual for hours worked in
excess of the workday be paid at a higher than standard rate. It is a common practice among
many employers to pay a standard wage for standard workday and to pay a relatively higher
wage rate for overtime work.
30 | P a g e
Premium wage rate is a payment made for hours worked in excess of the standard workday
where as a straight time equivalent wage rate provides an identical daily or weekly income from
the same number of hours of work. Many employment contracts under premium pay provide for
the payment of overtime compensation for hours worked in excess of 8 per day or 40 per week.
Under some contracts, such overtime compensation is fixed at one and one-half times the base
rate; under others, the overtime rate may be greater or less than one and one-half times the base
rate.
Suppose, for example, that in a given industry a 10-hour workday (50-hours workweek) becomes
commonplace. Does it make any difference with respect to work incentives to pay $6 per hour
for the first 8hours of work and $9 per hour for an additional 2 hours of overtime or pay $6.60
per hour for each 10 hours of work? Since both payment plans yield the same daily income of
$66 one is inclined to conclude that it makes no difference. However, we can find that it does
make a difference.
𝐰′
𝐔𝟐
𝐔𝟑
𝐈𝐂𝟑
𝐰
𝐈𝐂𝟐
𝐔𝟏
𝐈𝐂𝟏 𝐈𝐂𝟏
𝐋=𝟎 𝐇𝟐 𝐇𝟑 𝐇𝟏 𝐇=𝟎
31 | P a g e
We assume that the worker is initially at the optimal point on U1 , where HW is tangent to
indifference curve IC1 . At U1 the individual chooses to work HH1 hours, which we will
presume to be the standard workday. Let us now suppose that the employer offers additional
hours of overtime work at a premium pay. This renders the 𝐔𝟏 𝒘 segment of the 𝑯𝑾
irrelevant, and the budget constraint now becomes HU1 P. We observe that the optimal position
will move to U2 on the higher indifference curve IC2 and that the worker will choose to
work H1 H2 additional hours. Daily earnings will be U2 H2 .
Consider now the alternative of a straight-line equivalent wage, that is, a standard hourly wage
rate that will yield the same daily income of U2 H2 for HH2 hours of work. The straight line
equivalent wage can be shown by drawing a new budget line 𝐻𝑊’ through U2 . The budget lines
HU1 P and 𝐻𝑊’ will both yield the same monetary income of U2 H2 for HH2 hours of work. The
important point is that if confronted with 𝐻𝑊’, the worker will want to move from U2 to a new
optimal position at U3 , where fewer hours than HH2 are worked. Stated differently, at U2 the
indifference curve IC2 cuts 𝐻𝑊’ from above; that is, 𝑀𝑅𝑆𝐿,𝐶 is greater the wage rate. This
means that the worker subjectively values leisure more highly at the margin than does the
market, and, thus, U2 is no longer the optimal position under a straight-line pay arrangement.
Our worker will feel overemployed when working HH2hours on a straight time pay plan.
Conclusion: Premium wage rates for overtime work will call forth more hours of work than a
straight-time wage rate that yields the same income at the same number of hours as that actually
chosen by an individual paid the overtime. Why the difference? The use of premium pay will
have a relatively small income effect because it applies only to hours worked in excess of Hh1.
In comparison, the straight-time equivalent wage will have a much larger income effect because
it applies to all hours of work.
32 | P a g e
CHAPTER THREE: THEORY OF LABOUR DEMAND

In Chapter 2, we analyzed the motivations behind the individual decision to supply labour
services to a firm. We turn now to the other side of the coin and we study the demand for labour.
This is to say, we analyze how many workers a firm will decide to put on its payroll, when it will
be profitable for a firm to hire new workers and when it will be more likely that workers will be
fired.
It is worth pointing-out at this stage that many of the central questions in economic policy
involve the number of workers that firms employ and the wage that these workers are paid. Such
diverse policies as the minimum wage, employment subsidies, and restrictions in firing or laying
off workers are attempts to regulate various aspects of the firms’ labour demands.
3.1. The objective of the firm

Consider a company that produces some good or service, which sells at the market price. The
revenue of that firm is the price of each unit of output, P, times the number of units produced, Q.
(1) Revenue = P ∗Q.
This firm produces output by using factories, machines, office space, etc. (i.e. capital) and by
hiring a given number of employee hours (i.e. labour) to operate the machines and sell the good.
We will summarize the production capabilities of the firm by using the following production
function:
(2) Q = F(L, K)
Where L is the total number of hours the firm hires and K is the stock of capital. We will assume
that no output can be produced without using some labour and some capital and that an extra unit
𝜕𝐹 𝜕𝐹
of labour or capital increases output (𝑖. 𝑒. 𝜕𝐿 = 𝐹𝐿 > 0 𝑎𝑛𝑑 𝜕𝐾 = 𝐹𝐾 > 0).
The total cost of producing a given level of output for the firm is the number of hours of work it
hires times its price, the wage rate W, plus the amount of capital times its rental price, R:
(3) C= W∗L+R∗K
33 | P a g e
The objective of the firm is to choose the level of output that maximizes its profits (the
difference between revenue and cost). The demand for production inputs (such as capital and
labour) is a derived demand, in the sense that inputs are bought and rented for the contribution
that they make towards the production of the good or service that the firm sells.
3.2. Derived Demand for Labor

The demand for labor is a derived demand. That is demand for labor depends on or is derived
from the demand for the product or service the labor is helping to produce or provide. The
demand for labor is a derived demand. The strength of demand for a particular type of labor
depends on:
i. How productive that labor is in helping to create some product or service (Labor’s
marginal productivity)
ii. The market value of that item (Value (price) of its output)
3.2.1. The Demand for Labour in the Short Run
We will start by considering the case where capital is in place and cannot be expanded in the
̅ ). The analysis of the short run is of interest as the assumption that office
short run (i.e. 𝐾 = 𝐾
space, machines and other things cannot be expanded immediately to accommodate changes in
output is quite realistic. When the stock of capital is fixed, the only way to increase output in the
short run is to hire more hours of work. However, it is usual to assume that the increase in output
generated by an extra hour of work decreases as more hours of work are hired (i.e. 𝜕 2 𝐹/𝜕𝐿2 =
𝐹𝐿𝐿 < 0). This property is called the law of diminishing returns.
In the short run, when capital is fixed, the only part of the firm’s costs that is variable is the wage
bill (there is a fixed outlay equal to the cost of capital, R ∗ K). The choice of L, and therefore of
output, that maximizes the firm’s profit in the short run is obtained by setting the value of the
marginal revenue of labour equal to the marginal cost of labour. If the firm takes the product
price and the wage rate as given this condition can be written as
(4) 𝐏 ∗ 𝑭𝑳 (𝐋, 𝐤) = 𝐖. This is the equilibrium in the short run under perfectly competitive
market.
34 | P a g e
The demand for labour is determined by solving equation (4) in terms of L.
(5) ̅)
L = LSR (W, P, 𝐾
We obtain the supply of output in the short run.

(6) ̅ ), 𝐾
Q = F(LSR (W, P, 𝐾 ̅)
Mathematical derivation of the short run equilibrium (Perfectly competitive market)
π = TR − TC
i. Total value of product (TVP): it is the value of output
𝑇𝑉𝑃 = 𝑇𝑃 × 𝑃
Where TP is total product and P is price of output
𝛿𝑇𝑉𝑃
𝑆𝑙𝑜𝑝𝑒 = = 𝑉𝑀𝑃 = 𝑀𝑅𝑃𝐿
𝛿𝐿
Where, VMP is the value of marginal product

𝑀𝑅𝑃𝐿 is the marginal revenue product of labor
𝛿𝑇𝑉𝑃 (𝛿𝑇𝑃)𝑃
𝑉𝑀𝑃 = = = 𝑀𝑃𝐿 × 𝑃
𝛿𝐿 𝛿𝐿
ii. Total factor cost (FC): it is the cost of factors of production
𝐹𝐶 = 𝐿 × 𝑊
Where L is labor and W is wage
𝛿𝐹𝑐 (𝛿𝐿)𝑊
𝑆𝑙𝑜𝑝𝑒 𝑜𝑑 𝐹𝐶 = = =𝑊
𝛿𝐿 𝛿𝐿
The slope of FC is called marginal factor cost (MFC)
𝛿𝐹𝑐
𝑀𝐹𝐶 = =𝑊
𝛿𝐿
Therefore, at equilibrium, 𝑉𝑀𝑃 = 𝑀𝐹𝐶
𝑀𝑃𝐿 × 𝑃 = 𝑊
Alternatively,
π = TR − TC = P ∗ Q − W ∗ L
Since price is fixed
𝛿𝜋 𝛿𝑄 𝛿𝐿
=𝑃 −𝑊 =0
𝛿𝐿 𝛿𝐿 𝛿𝐿
35 | P a g e
𝑃 ∗ 𝑀𝑃𝐿 − 𝑊 = 0
𝑀𝑅𝑃𝐿 = 𝑉𝑀𝑃𝐿 = 𝑊
𝑉𝑀𝑃𝐿 = 𝑊
Mathematical derivation of the short run equilibrium (Monopoly market)
π = TR − TC = P ∗ Q − W ∗ L
Since price is not fixed
𝛿𝜋 𝛿𝑄 𝛿𝑃 𝛿𝐿
=𝑃 +𝑄 −𝑊 =0
𝛿𝐿 𝛿𝐿 𝛿𝐿 𝛿𝐿
𝛿𝑄 𝛿𝑃
𝑃 +𝑄 =𝑊
𝛿𝐿 𝛿𝐿
𝛿𝑄 𝛿𝑃 𝛿𝑄
𝑃 +𝑄( ∗ ) = 𝑊
𝛿𝐿 𝛿𝑄 𝛿𝐿
𝛿𝑄 𝛿𝑃
(𝑃 + 𝑄 ) = 𝑊
𝛿𝐿 𝛿𝑄
𝑀𝑃𝐿 ∗ 𝑀𝑅 = 𝑊
𝛿𝑃
Where, 𝑀𝑅 = 𝑃 + 𝑄 𝛿𝑄
𝑀𝑅𝑃𝐿 = 𝑊
Note that this equality (𝑉𝑀𝑃 = 𝑀𝑅𝑃𝐿 ) holds true under perfectly competitive market only.
However, for imperfectly competitive firm, price is not fixed, it declines as production increases
and the marginal revenue of an additional product is less than the price; 𝑀𝑅𝑃𝐿 < 𝑉𝑀𝑃.
Example: A restaurant owner has the following short-run production function:

̅ ) = 20√𝐿 .Workers hired for ETB 40 per day and the average meal is ETB 20.
Q = F(L, K
Where, 𝑄 = number of meals served per day, and 𝐿 = number of workers.
a. Formulate the labor demand equation of restaurant owner
b. How many workers should be hired?
c. Determine the numbers of meals served per day
At equilibrium, 𝑀𝑃𝐿 × 𝑃 = 𝑊
36 | P a g e
10
𝑀𝑃𝐿 =
√𝐿
10
( )𝑃 = 𝑊
√𝐿
After a little algebra, labor demand equation becomes
10𝑃 2
𝐿∗ = ( )
𝑊
∗
10(20) 2
𝐿 =( ) = (5)2 = 25
40
̅ ) = 20√𝐿 = 20√25 = 20 ∗ 5 = 100
Q∗ = F(L, K
Exercise 4:
1. Kashinen is the only grand hotel that exists around Shonga. The owner of this hotel has the
following short-run production function:
̅ ) = 20√𝐿 .He hired workers for ETB 40 per day. He also identified the market
Q = F(L, K
demand function as: P = 120 − 0.5Q
Where, 𝑄 = number of meals served per day, and 𝐿 = number of workers.
a. Formulate the labor demand equation of restaurant owner
b. How many workers should be hired?
c. Determine the numbers of meals served per day
d. Determine the price of average meal
2. The MRP of labor is given by the following equation: 𝑀𝑅𝑃1 = 20 − 𝐿, where 𝐿 = number
of workers.
a. If the market wage is $5 per hour, how many workers will the employer want to hire?
b. The employer now finds that employees will work harder if they are paid a higher wage. If the
wage rate paid the workers is at least $6 per hour, the higher productivity of labor is represented
by the new marginal revenue product of labor curve: 𝑀𝑅𝑃2 = 22 − 𝐿. How many workers
would the employer want to hire at $6 per hour?
c. Use economic theory to explain the change in employment levels associated with paying $6
instead of $5.
37 | P a g e
3.2.2. The Demand for Labour in the Long Run

Let us consider now the demand for labour when the firm can adjust both capital and
employment (labor). The firm now wants to determine what are the combination of inputs, and
therefore the level of output, that maximizes profits. A graphical and a mathematical analysis of
the equilibrium require the definition of two terms: isoquants and isocosts.
The production function (Q = F(L, K))defines the minimal amount of capital and labour that are
required to produce a given level of output. An isoquant is the minimal combination of capital
and labour that allows the firm to produce a given level of output. The slope of an isoquant, the
marginal rate of technical substitution, is negative. If the firm reduces employee hours in one
unit, it must increase the capital level by some amount in order to maintain the output level
constant, as both inputs are productive. The isoquants are convex to the origin because the higher
the level of employee hours the smaller is the increase in capital level required to compensate for
a reduction in labour while keeping the level of output constant.
Mathematical derivation of Long Run equilibrium

There are two approaches in determining producers' equilibrium.
i. Maximizing profit for a given cost of production(maximization of output subjected to
cost constraint)
ii. Maximizing profit for a given level of output(cost minimization or least cost combination
of inputs)
i. Maximizing profit for a given cost of production
This approach is suitable when a firm has a fixed budget for its production.
̅̅̅̅
↑ 𝜋 = 𝑃̅ × 𝑄 ↑ −𝑇𝐶
The optimization problem can be formulated as follows:
𝑀𝑎𝑥𝜋 = 𝑓(𝐿, 𝐾) 𝑠. 𝑡 𝐶 = 𝑤𝐿 + 𝑟𝐾
𝑀𝑎𝑥𝜋 = 𝑓(𝐿, 𝐾), this is the objective function
𝐶 = 𝑤𝐿 + 𝑟𝐾, this is the constraint function
To solve the constraint problem, we use Lagrangian multiplier method.
Ω = 𝑓(𝐿, 𝐾) − λ(𝑤𝐿 + 𝑟𝐾 − 𝐶)
38 | P a g e
First order condition for maximum is that the partial derivative of the function with respect to
each of the independent variable is equal to zero.
𝜕Ω 𝜕𝑓(𝐿,𝐾) 𝑀𝑃𝐿
=0= − λ𝑤 = 0 ⇒ λ =
𝜕𝐿 𝜕𝐿 𝑤
𝜕Ω 𝜕𝑓(𝐿,𝐾) 𝑀𝑃𝐾
=0= − λ𝑟 = 0 ⇒ λ =
𝜕𝐾 𝜕𝐾 𝑟
𝜕Ω
= 0 = −𝑤𝐿 − 𝑟𝑘 + 𝐶 = 0 ⇒ 𝐶 = 𝑤𝐿 + 𝑟𝐾
𝜕λ
λ=λ
𝑀𝑃𝐿 𝑀𝑃𝐾 𝑀𝑃𝐿 𝑤 w
= ⇒ = ⇒ MRTSL,K =
𝑤 𝑟 𝑀𝑃𝐾 𝑟 r
Numerical Example: suppose firm's production technology in the long run is given by:
𝑄 = 3𝐿 + 5𝐾 + 𝐿𝐾
The price of labor is 3 Birr per unit and the price of capital is 6 Birr per unit. If the firm capital is
limited to say 123 Birr only, determine the maximum amount of output that maximizes its profit.
Ω = 3𝐿 + 5𝐾 + 𝐿𝐾 − λ(3𝐿 + 6𝐾 − 123)
𝜕Ω 3+𝐾
= 0 = 3 + 𝐾 − 3λ = 0 ⇒ λ =
𝜕𝐿 3
𝜕Ω 5+𝐿
= 0 = 5 + 𝐿 − 6λ = 0 ⇒ λ =
𝜕𝐾 6
𝜕Ω
= 0 = −3𝐿 − 6𝑘 + 123 = 0 ⇒ 123 = 3𝐿 + 6𝐾
𝜕λ
λ=λ
3+𝐾 5+𝐿
= ⇒ L = 2K + 1
3 6
Substitute L = 2K + 1 in to 3𝐿 + 6𝐾 = 123, then we get 𝐾 = 10 and after substituting the K's

value in to L = 2K + 1, we get L = 21. The maximum output of the firm becomes 𝑄 = 323.
ii. Maximizing Profit for a Given Level of Output (Cost Minimization)
This approach is used when a firm has produce a fixed quantity of a particular product.
↑𝜋=̅ ̅ − TC ↓
P×Q
The problem of cost minimization can be formulated as follows:
𝑀𝑖𝑛 𝐶 = 𝑤𝐿 + 𝑟𝐾 𝑠. 𝑡 𝑄̅ = 𝑓(𝐿, 𝐾)
To solve the constraint problem, we can also use Lagrangian multiplier method.
Ω = 𝑤𝐿 + 𝑟𝐾 − λ[𝑓(𝐿, 𝐾) − 𝑄̅ )]
39 | P a g e
First order condition for minimum is that the partial derivative of the function with respect to
each of the independent variable is equal to zero.
𝜕Ω 𝜕𝑓(𝐿,𝐾) 𝑤
=0=𝑤−λ = 0 ⇒ λ = 𝑀𝑃
𝜕𝐿 𝜕𝐿 𝐿
𝜕Ω 𝜕𝑓(𝐿,𝐾) 𝑟
=0=𝑟−λ = 0 ⇒ λ = 𝑀𝑃
𝜕𝐾 𝜕𝐾 𝐾
𝜕Ω
= 0 = 𝑄̅ − 𝑓(𝐿, 𝐾) = 0 ⇒ 𝑄̅ = 𝑓(𝐿, 𝐾)
𝜕λ
λ=λ
𝑤 𝑟 𝑀𝑃𝐿 𝑤 w
= 𝑀𝑃 ⇒ = ⇒ MRTSL,K =
𝑀𝑃𝐿 𝐾 𝑀𝑃𝐾 𝑟 r
Example:
Consider the previous example, suppose a firm would like to produce a fixed amount of output
say 323 units and the firm's production technology in the long run is given by: 𝑄 = 3𝐿 + 5𝐾 +
𝐿𝐾. The price of labor is 3 Birr per unit and the price of capital is 6 Birr per unit.
a. Determine the least cost combination of producing 323 units of output
b. Determine the minimum cost of producing 323 unit of output.
Ω = 𝑤𝐿 + 𝑟𝐾 − λ[𝑓(𝐿, 𝐾) − 𝑄̅ )]
Ω = 3𝐿 + 6𝐾 − λ[3𝐿 + 5𝐾 + 𝐿𝐾 − 323]
Use first order condition for minimum 𝐶
𝜕Ω 3
= 0 = 3 − λ(3 + 𝐾) = 0 ⇒ λ = 3+𝐾
𝜕𝐿
𝜕Ω 6
= 0 = 6 − λ(5 + 𝐿) = 0 ⇒ λ = 5+𝐿
𝜕𝐾
𝜕Ω
= 0 = −3𝐿 − 5𝐾 − 𝐿𝐾 + 323 = 0 ⇒ 323 = 3𝐿 + 5𝐾 + 𝐿𝐾
𝜕λ
λ=λ
3 6
=
3+𝐾 5+𝐿
𝐿 = 2𝐾 + 1
Substitute L = 2K + 1 in to 323 = 3𝐿 + 5𝐾 + 𝐿𝐾, then we get 𝐾 = 10 and after substituting
the K's value in to L = 2K + 1, we get L = 21. These are the least cost combination of producing
323 units of output. The minimum cost of producing 323 units of output becomes 𝐶 = 3𝐿 +
6𝐾 = 3(21) + 6(10) = 123.
Exercise 5:
40 | P a g e
1. Axum jewelry is an earring design and manufacturing company. The production function for
earrings is 𝑄 = 𝑓(𝐿, 𝑘) = 25𝐿𝐾, where 𝑄 = pairs of earrings per week, 𝐾 = hours of
equipment used, and 𝐿 = hours of labor. Workers are paid $8 per hour, and the equipment rents
for $8 per hour.
i. Determine the least cost combination of producing 10,000 pairs of earrings.
ii. How much does it cost to produce 10,000 pairs of earrings?
iii. Suppose the rental cost of equipment decreases to $6 per hour. What is the new cost to
produce 10,000 pairs of earrings?
2. Sheba leather factory produces shoes at its factory. Both its labor and capital markets are
competitive. Wages are $12 per hour, and shoe making equipment rents for $4 per hour. The
production function is, 𝑄 = 40𝐾 0.25 𝐿0.75, where 𝑄 = pairs of shoes per week, 𝐾 = hours of
shoe equipment used, and 𝐿 = hours of labor.
i. Determine the least cost combination of producing 5,000 pairs of shoes.
ii. How much does it cost to produce 5,000 pairs of shoes?
3. The following table shows the number of cakes that could be baked daily at a local bakery,
depending on the number of bakers.
Number of Bakers Number of Cakes

0 0
1 10
2 18
3 23
4 27
a. Calculate the 𝑀𝑃𝐿 .

b. Do you observe the law of diminishing marginal returns? Explain.
c. Suppose each cake sells for $10. Calculate the 𝑀𝑅𝑃𝐿
d. Draw the 𝑀𝑅𝑃𝐿 curve, which is the demand curve for bakers.
e. If each baker is paid $80 per day, how many bakers will the bakery owner hire,
given that the goal is to maximize profits? How many cakes will be baked and
sold each day?
41 | P a g e
3.3. Elasticity of Labor Demand

Elasticity of labor demand measures the sensitivity of employment to a change in the wage rate.
Wage elasticity measures the sensitivity of the quantity of labor to wage rate change; it is
measured by the wage elasticity coefficient ∈𝑑 :
𝛿𝑄𝐿 𝑊 δlog QL
∈𝑑 = =
𝛿𝑊 𝑄𝐿 δ log W
It measures percentage change in employment induced by one percent change in the wage rate.
Demand is elastic – meaning that employers are quite responsive to a change in wage rates – if a
given percentage change in the wage rate results in a larger percentage change in the quantity of
labor demand. In this case the absolute value of the elasticity coefficient will be greater than 1.
Conversely, demand is inelastic when a given percentage changes in the wage rate causes a
smaller percentage change in the amount of labor demanded. In this instance ∈𝑑 will be less than
1, indicating that employers are relatively insensitive to changes in wage rate. Finally, demand is
unit elastic – meaning that the coefficient is 1 – when a given percentage in the wage rate causes
an equal percentage in the amount of labor demanded.
Is the demand for labour more elastic in the long run than in the short run? Yes. Why is that the
case? There are two main explanations. First, in the long run the firm can substitute away from
labour by using capital when the wage rate rises. Second, in the short run the demand for output
is less elastic. Therefore, any change in the wage rate (and thus on output price) has a larger
effect on employment in the long run.
Example:
Given the non-linear labor demand function of an employer 𝑄𝐿 = 2𝑊 −0.6.
Find the elasticity of labor demand.
A more convenient way to solve this problem is by the use of logarithms. Taking logarithm of
each side, we have,
𝑙𝑛𝑄𝐿 = 𝑙𝑛(2𝑊 −0.6 )
𝑙𝑛𝑄𝐿 = 𝑙𝑛2 + 𝑙𝑛𝑊 −0.6
𝑙𝑛𝑄𝐿 = 𝑙𝑛2 − 0.6𝑙𝑛𝑊
Differentiating 𝑄𝐿 with respect to 𝑊, we get
δln QL
= −0.6
δ ln W
42 | P a g e
δln QL
∈𝑑 = = −0.6
δ ln W
Exercise 6
1. Suppose that the demand for dental hygienists is 𝐿𝐷 = 5,000 – 20𝑊, where L = the number
of dental hygienists and W = the daily wage. What is the own-wage elasticity of demand for
dental hygienists when W = $100 per day? Is the demand curve elastic or inelastic at this point?
What is the own-wage elasticity of demand when W = $200 per day? Is the demand curve elastic
or inelastic at this point?
2. Union A faces a demand curve in which a wage of $4 per hour leads to demand for 20,000
person-hours, and a wage of $5 per hour leads to demand for 10,000 person hours. Union B faces
a demand curve in which a wage of $6 per hour leads to demand for 30,000 person-hours,
whereas a wage of $5 per hour leads to demand for 33,000 person-hours.
a. Which union faces the more elastic demand curve?
b. Which union will be more successful in increasing the total income (wages times person-
hours) of its membership?
3. Suppose that the inverse demand function for a daily workers is 𝑊 = 50– 0.1𝑄𝐿 . Where 𝑄𝐿 =
the number of daily workers and W = the daily wage. Find the numbers of workers that must be
hired and the daily wage that must be paid when the wage elasticity of demand is unitary.
3.3.1. Determinants of Elasticity of Labor Demand
The factors that determine the elasticity of labour demand have been summarised by Alfred
Marshall as follows:
i. Elasticity of product demand: because the demand for labor is a derived demand, the
elasticity of demand for labor’s output will influence the elasticity of demand for labor.
Other things being equal, the greater the price elasticity of product demand, the greater
the elasticity of labor demand.
ii. Ratio of labor cost to total cost: other things being equal, the larger the proportion of total
production costs accounted for by labor, the greater will be the elasticity of demand for
labor.
43 | P a g e
iii. Substitutability of other inputs: other things being equal, the greater the substitutability of
other inputs for labor, the greater will be the elasticity of demand for labor.
iv. Supply elasticity of other inputs: Other things being equal, the greater the elasticity of the
supply of other inputs, the greater the elasticity of demand for labor.
44 | P a g e
CHAPTER FOUR: WAGE DETERMINATION AND WAGE STRUCTURE

The proportion of wages in the national income is in excess of 60 percent in most countries. In
the industrialized countries, the wage bill accounts for a much higher share of the gross national
income than in many developing countries. Wages, therefore, constitute a most important
determinant of economic growth.
4.1. Wage Determination and Wage Structures
4.1.1. Wage Determination on a Perfectly Competitive Market
We can readily apply the models learned in introductory microeconomics to the labor market. As
in the market for wheat, the demand curve for labor is downward sloping. The higher the price of
labor, the less firms demand of it. The demand curve is the sum of the labor demands of many
individual firms. The supply curve is upward sloping. The higher the price of labor, the more
workers will supply of it. The supply curve is the sum of the labor supply of many individual
workers.
This type of labor market is typically characterized by a large number of firms (employers) and
workers. The firms have a large pool of workers to choose from and the workers have a large
number of employers to choose from. This creates competition for jobs among workers and
competition among firms for workers. No firm or worker has any market power and therefore
cannot influence the market price of labor, the wage rate.
Equilibrium is reached when the labor demanded by firms is equal to the labor supplied by
workers. This is the point of intersection of the labor supply and labor demand curves. At this
point, we have an equilibrium number of labor hours employed in the economy 𝐻 ∗ and an
equilibrium wage rate 𝑊 ∗ . A workers are paid 𝑊 ∗ and the total number of hours worked in the
economy is 𝐻 ∗ .
The equilibrium condition can be summarized as
𝑯∗𝒔 (𝒘∗ ) = 𝑯∗𝒅 (𝒘∗ )
Where Hs∗ (w ∗ ) is the optimal labor supply (of all workers) at the wage 𝑊 ∗ , and Hd∗ (w ∗ ) is the
optimal labor demand (of all firms) at the wage 𝑊 ∗ .
45 | P a g e
Wage rate 𝑳𝒔
𝒘∗
𝑳𝑫
𝐇∗ Quantity of Labor
Example: Suppose that the supply curve for schoolteachers is 𝐿𝑆 = 20,000 + 350𝑊, and the
demand curve for schoolteachers is 𝐿𝐷 = 100,000 − 150𝑊, where 𝐿 = the number of teachers
and 𝑊 = the daily wage. What are the equilibrium wage and employment levels in this market?
At equilibrium, 𝐿𝑆 = 𝐿𝐷
20,000 + 350𝑊 = 100,000 − 150𝑊
500𝑊 = 80,000
𝑊 ∗ = 160
The equilibrium employment levels is,
𝐿∗𝑆 = 20,000 + 350𝑊
𝐿∗𝑆 = 20,000 + 350(160)
𝐿∗𝑆 = 76,000
4.1.2. Monopoly and Wage Determination

The assumption here is that the firm (the monopolist) is a wage taker in the labour market but a
price-maker in the product market. In other words, it operates in a competitive labour market and
sells its output in a monopolistic product market. Monopolist firms restrict output and raise
output prices relative to firms in a competitive product market. These monopolist firms often
earn higher profits than firms in competitive output markets. An interesting question for the labor
market is who gets to keep these rents: labor or capital. The monopolist firm could return at least
46 | P a g e
part of these rents to the workers in form of higher wages or give them to the owners of the
capital (the firm’s owners). Because of the presence of these rents, the employees of monopolist
firms may have a greater opportunity to extract higher wages from monopolist firms than from
firms in competitive product markets.
4.1.3. Monopsony in the Labor Market

If there is only one firm in a labor market, this firm is called a monopsonist. The one firm is the
one employer or consumer of labor. A monopsonist could be the one employer in a geographic
area) or, the monopsonist firm could be the one employer of a particular occupation or set of
skills. In addition, groups of independent firms may join together in the form of a cartel to act
jointly as a monopsonist employer.
Typically, monopsonist firms employ less labor (lower labor demand) than a competitive firm.
The lower labor demand pushes the equilibrium wage rate in a labor market with a monopsonist
firm lower than the equilibrium wage rate in a competitive labor market. In addition,
monopsonist firms typically earn higher profits than firms in a competitive labor market do. To
maintain the market power of the monopsonist, there must be some sort of labor market friction,
which prevents other firms from entering this labor market.
4.1.4. Monopoly in the Labor Market
If there is only one worker in a labor market, the one worker is a monopolist in this labor market.
Although true monopoly labor markets are probably non-existent, many workers enjoy some
level of market power in their labor market. An example would be entertainers or athletes for
which there are only limited or imperfect substitutes.
Typically, monopolist workers restrict the amount of their labor supply. Just like a monopolist
firm in the product market, this supply restriction increases the equilibrium wage monopolist
worker receives relative to a competitive labor market. If there were many good substitutes for
certain entertainers or athletes, their market power would dissipate and the wages they receive
would fall. There must be some sort of labor market friction that prevents individuals from
entering these markets and capturing the rents the monopolist workers receive. For example, my
lack of talent prevents my entry into the basketball labor market.
47 | P a g e
4.1.5. A Bilateral Monopoly Problem

If there is both a single monopsonist firm and a single monopolist worker, the market structure is
called a bilateral monopoly. In this labor market, both the firm and the worker have market
power. How the equilibrium wage rates and labor hours are determined in this market is an open
question.
4.2. Wage Structures

4.2.1. Perfect Competition: Homogeneous Workers and Jobs
In order to examine what the wage structure will look like under perfectly competitive market,
let us assume that all employees and firms in the economy are homogeneous (i.e. homogeneous
worker and jobs). It is easy to see that if information is perfect and job searches and migration
are costless, labour resources will flow among various employments and regions of the economy
until all workers have the same wage.
𝑆𝐴
W W 𝑆𝐵′
𝑆 ′𝐴
10 𝑆𝐵
7.50
7.50
𝐷𝐴 = 𝑉𝑀𝑃𝐴 5
𝐷𝐵 = 𝑉𝑀𝑃𝐵
𝑄𝐴 𝑄𝐴′ 𝐐𝐋 𝑄𝐵′ 𝑄𝐵 𝐐𝐋
The process whereby wages equalize is demonstrated in figure above. Initially assume that
labour demand and supply are 𝐷𝐴 and 𝑆𝐴 in sub-market A and 𝐷𝐵 and 𝑆𝐵 in sub market B,
respectively. Notice that these supply and demand conditions produce an hourly wage rate of 10
birr in sub market A as compared to a 5 birr wage in B. In each instance the wage rate equals the
value of marginal product (VMP) of labour, but not that the VMP of the 𝑄𝐵 worker in sub
market B is less than the wage rate and VMP of the 𝑄𝐴 employee in sub market A. The
consequence is workers will exist sub market B and take jobs in higher paying A. The decline in
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labour supply in B from 𝑆𝐵 to 𝑆𝐵′ and the increase in A from 𝑆𝐴 to 𝑆𝐴′ will cause the equilibrium
wage in A to drop from birr 10 to birr 7.50. The market clearing wage in sub market B will rise
from birr 5 to birr 7.50. Following the migration of workers between the two sub markets:
i. The wage rates will be equal (birr 7.50), (i.e.; 𝑊𝐴 = 𝑊𝐵 )
ii. These wages will equal the VMPs in each sub market, and (i.e. 𝑊𝐴 = 𝑉𝑀𝑃𝐴 and 𝑊𝐵 =
𝑉𝑀𝑃𝐵 )
iii. The VMPs will equal each other. (i.e. 𝑉𝑀𝑃𝐴 = 𝑉𝑀𝑃𝐵 )
We may thus summarize as follows: If all jobs and workers are homogenous and there is perfect
mobility and competition, the wage structure defined as the array of wage rates paid to workers
will evidence no variability. The average wage rate will be the only wage rate in the economy.
4.2.2. The Wage Structure: Observed Differentials
Causal observation of the economy reveals that in fact wage differentials do exist and that many
of them persist overtime. What causes these wage differentials and how can they persist? Why
do some wage differences narrow overtime while other remains? More specifically, wage
differentials occur because
i. Jobs are heterogeneous,
ii. Workers are heterogeneous,
iii. Labour markets are imperfect.
4.2.2.1. Wage Differentials: Jobs are heterogeneous
Previously, we assumed that jobs were identical to one another in all respects. Utility
maximizing employees thus needed only to consider the wage rate itself in deciding where to
work. Higher wages in one sub market would attract workers there. However, in reality, jobs
are heterogeneous rather than homogeneous. In particular, heterogeneous jobs have differing
non-wage attributes and require different types and degrees of skill. Additionally, employers
vary with respect to such things as union status; firm size; strategies for attracting, screening and
retaining workers; and personal taste for discrimination.
4.2.2.1.1. Compensating Differentials
The theory of compensating differentials states that workers are paid to compensate them for
non-wage (non-pecuniary) aspects of jobs. Undesirable jobs, such as jobs with high risk of injury
(e.g. police officer), or jobs with poor working conditions (e.g. coal miner), must offer higher
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wages in order to get people to work in these jobs. On the other hand, jobs with desirable
characteristics, (e.g. good location, more benefits, or nice office furniture) can offer lower wages
and still attract workers.
Non-wage aspects of jobs vary greatly and are the source of compensating wage differentials.
These differentials consist of the extra pay that an employer must provide to compensate a
worker for some undesirable job characteristics that does not exist in an alternative employment.
Compensating wage differentials are thus equilibrium wage differences, since they do not cause
workers to shift to the higher-paying jobs.
In our previous discussion, we assumed that the jobs shown in labour sub markets A and B were
homogeneous. Now let us suppose instead that the jobs in sub market A are performed in an
unpleasant weather throughout the year while the work in B occurs in pleasant surroundings.
Because of the indicated differences in non wage amenities (i.e. different working conditions)
between sub markets A and B, labour supply will be less in A relative to B. If, for example, the
equilibrium wage rate in A will be birr 10 as contrasted to birr 5 in sub market B. The extra 5
birr paid in A is called a wage premium, compensating wage differential, or equalizing
difference. No movement of workers from B to A will occur, as happened when jobs were
assumed homogeneous. This 5 birr wage differential will persist; it will change only in response
to change in the other determinants of supply and demand in either of the two labour markets.
4.2.2.1.1.1. A Model of Compensating Differentials

To think about a compensating differentials model, re-write our labor supply utility function to
include a Z variable. Z represents the non-pecuniary characteristics of a job. The utility function
is then 𝑈(𝐶, 𝐿, 𝑍). Z is a desirable characteristic. Higher levels of Z increase the worker’s utility
𝜕𝑈(𝐶, 𝐿, 𝑍)
>0
𝜕𝑍
Suppose there are two firms. Firm A offers a wage 𝑊𝐴 and Firm B offers a wage of 𝑊𝐵 . Both
firms offer a package of non-pecuniary benefits: 𝑍𝐴 and 𝑍𝐵 .
We make the following assumptions:
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i. Firm A offers a higher level of non-pecuniary benefits: 𝑍𝐴 > 𝑍𝐵 .

ii. The wage offers are the same: 𝑊𝐴 = 𝑊𝐵 .
Under these assumptions, all workers will receive higher utility from working at Firm A.
Therefore, every worker will choose to work at Firm A. In order for Firm B to compete and
attract workers, it must compensate the workers for the higher utility workers receive by working
at Firm A.
Suppose Firm B cannot adjust its level of non-pecuniary benefits (e.g. the firm is located in a bad
location and cannot move). However, Firm B can adjust its wage offer. In order to make workers
just indifferent between Firm A and Firm B, Firm B must increase its wage offer.
To calculate the amount Firm B needs to increase its wages, first we need to calculate the
indirect utility workers receive from a firm as a function of wages and non-pecuniary benefits.
Let 𝑉 (𝑍𝐴 , 𝑊𝐴 ) be the amount of utility workers receive from working at Firm A. Workers
receive 𝑉 (𝑍𝐵 , 𝑊𝐵 ) from Firm B. The difference in utility is then
𝑉 (𝑍𝐴 , 𝑊𝐴 ) − 𝑉 (𝑍𝐵 , 𝑊𝐵 ) > 0
̃𝐵 > 𝑊𝐵 in order to equalize utility:

Firm B calculates that it needs to raise wages to 𝑊
̃𝐵 ) = 0
𝑉 (𝑍𝐴 , 𝑊𝐴 ) = 𝑉 (𝑍𝐵 , 𝑊
̃𝐵 > 𝑊𝐴 .
Note that the wage offer Firm B offers is now greater than the wage offer at Firm A: 𝑊
̃𝐵 − 𝑊𝐴 , is the compensating differential for the difference in
The difference in the wage offers, 𝑊
non-pecuniary characteristics, 𝑍𝐴 − 𝑍𝐵 .
4.2.2.1.1.2. Using Compensating Differentials

Compensating differentials help to explain differences in wages across jobs and firms. Another
use of compensating differentials is to enable economists to price characteristics that have no
readily available prices. We could ask people how much they value characteristics of jobs. For
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example, we could survey people and ask them how much they would pay for their firm to move
to a more desirable location. Nevertheless, it may be the case that this information would not be
as accurate as using the actual observed behavior of people in the market. Consider the following
two examples:
I. What is the value of a human life?
Two firms differ in the risk of death on the job. An example would be two coalmines and one of
the mines has a higher risk of fatal accidents. At Firm A, the risk of death is 𝑃𝐴 . In one year, a
worker has𝑃𝐴 probability of dying. The riskier mine, Firm B, has a risk of death of 𝑃𝐵 > 𝑃𝐴 .
Firm A pays an annual wage of 𝑊𝐴 . Firm B pays a wage of 𝑊𝐵 > 𝑊𝐴 .
If we think that these wage differentials are compensation for the higher risk of death in Firm B,
then we can use these differentials to calculate a worker’s value of her life. Workers are willing
to trade 𝑊𝐵 − 𝑊𝐴 dollars for a 𝑃𝐵 − 𝑃𝐴 higher probability of death.
Assume that the probability of death is 0.001 greater in Firm B.

𝑃𝐵 = 𝑃𝐴 + 0.001
The annual salary differential is
𝑊𝐵 = 𝑊𝐴 + $6,600
Assume each firm employs 1,000 workers. The difference in the probability of death between the
two firms implies that in a given year, one more worker will die in Firm B than in Firm A. Each
worker in Firm B requires $6,600 in additional wages each year to compensate them for this risk.
If there are 1,000 workers, Firm B is essentially buying one human life for 1,000 x $6,600 or 6.6
million dollars.
II. What is the value of school quality?
This is a non-labor market example. Some researchers have used differences in house prices to
examine how much parents value differences in school quality.
Suppose here are two houses on opposite sides of the street: House A and House B. The street
forms a boundary between two school districts. The children from House A attend School A and
the children from House B attend School B. The two schools have different levels of quality,
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measured by the average test scores of the students who attend the schools. The test scores for
School A are 𝑇𝐴 and are greater than the test scores in School B: 𝑇𝐴 > 𝑇𝐵 . The price of House A
is 𝑃𝐴 is higher than the price of House B: 𝑃𝐴 > 𝑃𝐵 . A compensating differentials model would
indicate that we can use the difference in the prices of the houses, 𝑃𝐴 − 𝑃𝐵 , to measure how
much parents value the difference in test scores, 𝑇𝐴 − 𝑇𝐵 .
4.2.2.1.1.3. Sources of Compensating Differentials

Having established the basic principle of compensating wage differentials, we next examine each
of the following sources of compensating differentials:
a) Risk of job injury or death: the greater the risk of being injured or killed on the job, the
less the labour supply to a particular occupation. Hence, jobs which have high risks of
accidents relative to others requiring similar skill will command compensating wage
differentials
b) Fringe benefits vary greatly among employers who hire similar workers and pay
similar wage rate: suppose that same firms which hire a specific grade of labour pay
only 8 birr an hour while others pay the 8 birr plus provide such fringe benefits as sick
leave, paid vacations, and medical and dental insurance. Obviously, other thing being
equal, workers will choose to offer their services to these latter employers. To attract
qualified employees, the firms that do not provide fringe benefits will be forced to pay a
compensating wage differential that in effect will equalize the gross hourly compensation
between the two groups.
c) Job Status: some jobs offer high status and prestige and hence attract a large number of
willing suppliers; other employment carries with it the social stigma of being uninspiring
and dirty. To the extent that labour supply behavior is affected by status seeking,
compensating wage differentials may emerge between low and high-prestige work.
d) Job location: Similar jobs also differ greatly with respect to their location, which in turn
vary as to their amenities and their living costs. Cities noted for their “livability” may
attract a larger supply of workers in a specific occupation than cities mainly noted for
their smokestack industries. Consequently, compensating differentials may arise.
e) Job security (regularity of earnings): some jobs provide employment security for long
periods and explicit or implicit assurances that one will work full weeks throughout the
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year. Other positions, for example, construction, consulting, and commissioned sales are
characterized by variability of employment, variability of earnings, or both. Since a
specific paycheck is not assured each week of the year, fewer workers may find these
occupations attractive and, all else being equal, people who do work in these jobs may
receive a compensating wage differentials.
f) Prospect of wage advancement: jobs are also heterogeneous with respect to the amount
of firm financed investment in human capital provided over the years. Assuming that
people’s time preferences for earnings are the same, at any given wage people will opt for
jobs, which have greater prospects for earnings increases. Hence labour supply will be
greater to these jobs and less to employment characterized by flat lifetime earnings
streams. This will necessitate a compensating wage differential for entry-level pay in the
latter type of occupation.
g) Extent of control over the work place: some jobs provide less personal control of the
workplace and less flexibility in work hours than other position. More people are likely
to prefer the latter jobs to the former, and therefore an equalizing wage differential may
result.
4.2.2.1.1.4. Problems with Compensating Differentials

a) People must know the actual differences: The compensating differentials model
assumes that the decision makers know what the actual differences in characteristics are.
The miners must know what the difference in the risk of death is between the two mines.
The homeowners must know the difference in test scores between the two schools. If
decision makers (workers, homeowners) are acting on inaccurate information, then the
compensating differential we observe in wages and home prices are meaningless.
b) Must control for all other differences: in reality, using compensating differentials
requires controlling for all other characteristics of job or good. Ideally, the compensating
differentials model only applies to situations where the job or goods being compared are
exactly the same, except for the one characteristic we are interested in. For example,
mines could differ in the risk of death and in other factor such as life insurance benefits.
The riskier mine could offer its workers more life insurance benefits than the other mine.
The two houses could be very different from each other–one could have 2,000 square feet
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and the other only 1,000 square feet. If we do not take these other factors into account in
some way, the results from a compensating differentials analysis are biased.
4.2.2.2. Wage Differentials: Heterogeneous Workers

Having observed that heterogeneities among jobs and employers constitute a major source of
wage disparities, we now turn to an equally important factor, which influences the wage
structure: heterogeneous workers. The wage equality initially predicted in the above figure relied
on the assumption not only that all jobs were identical but also that all workers in the labour
force were equally productive. In reality, people have greatly differing stocks of human capital
as well as differing preferences for non-wage aspects of jobs.
i. Differing Human Capital: Non-competing Groups

People obviously are not homogeneous. Of particular significance to our discussion of the wage
structure is the fact that people possess differing stocks of human capital. Hence, at any point in
time the labour force consist of numerous non-competing groups, each one of which represents
one or several occupations for which the members of the group qualify.
There is no effective competition in the labour market between these groups and larger groups of
skilled or unskilled workers. Nor is there substitutability between them. Non-competing groups
result from differences in the type, amount, and quality of education and training which people
possess.
Workers can do more from one non-competing group to another by investing in human capital.
However, this presupposes the person has the financial means and innate intelligence needed to
pursue this degree successfully. To the extent that income, credit worthiness, and native learning
skills are unequally distributed, wage differentials between non competing groups can persist.
Also, bear in mind that the quality of education varies.
To summarize: people have differing stocks of human capital according to native endowments
and the type, amount, and quality of education and training they posses. Unsurprisingly, the
result is a wide variety of groups, subgroups, or even individuals who are not readily
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substitutable for one another in the labour market. In the short run, these human capital
heterogeneities produce wage differentials due to the varying productivity of workers. People
can and do move toward the higher-paying positions in the long run, but the extent of the
movements is limited by differing abilities to finance human capital investments and differing
inherent abilities to absorb and apply education and training. Therefore, wage differentials
remain.
ii. Differing individual preferences

In addition to possessing differing stocks of human capital, people also are heterogeneous with
respect to their preferences for such things as:
a) Differences in time preferences
Some people are highly present oriented; that is, they discount the future heavily or ignore it
entirely. Other people have a greater willingness or ability to sacrifice present satisfaction to
obtain greater future rewards. Those persons who are highly present oriented will not be willing
to sacrifice consumption today unless as a result they are able to obtain substantially more birr in
the future, and hence the less the likelihood that one will undertake a given investment in human
capital. On the other hand, people who are future oriented will be willing to forgo current
consumption for the expectation of obtaining relatively small additions to earnings later and
hence will perceive a given investment in human capital to have a higher net present value.
Consequently, they will obtain more human capital than the present oriented individuals will.
b) Tastes for Non-wage Aspects of Jobs

We noted earlier that jobs are heterogeneous with respect to such non-wage features as
probability of job accidents, fringe benefits, job status, location, regularity of earnings, prospects
for wage advancement, and control over the work place. People also differ as to their
preferences for these non-wage amenities and disamenities; workers as well as jobs are
heterogeneous in this regard. As examples, some workers value job safety highly while others
are far less averse to risks, some people desire positions having paid vacations while others find
vacations boring and would gladly forgo paid absences for higher hourly pay, some individuals
seek status while others do not care what people think of their occupations.
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4.2.2.2.1. The Hedonic Theory of Wages

The fact that both jobs and workers are heterogeneous is contained in the hedonic theory of
wages. The term hedonic derives from the philosophical concept of hedonism which
hypothesizes that people pursue that which provides utility (pleasure), say wage income, and
avoid that which creates disutility (pain), for example jobs having unpleasant working
conditions. According to the hedonic theory, workers are interested in maximizing net utility
and therefore are willing to exchange that which produces utility to get reductions in something,
which yields disutility.
Thus, a hedonic wage function reflects the relationship between wages and job characteristics. It
matches workers with different risk preferences with firms that can provide jobs that match these
different risk preferences.
a) The worker’s Indifference Map

The hedonic wage theory often is portrayed in terms of a trade-off between a good (the wage)
and a bad (the probability of injury). However, the absence of a bad (probability that an injury
will not occur) is indeed a good, and therefore the theory can be presented in terms of trading off
wages and non-wage amenities. This allows the use of standard indifference curve analysis. It is
reasonable to assume that the typical worker places a positive value on (i) the wage rate being
paid, and (ii) the non-wage amenities that a job offers. Hence, in a manner similar to the income
leisure analysis we seen in labor supply theory, worker faces a subjective trade-off between two
things that yield utility. In figure (a) and (b) below the wage rate is measured on the vertical axis
and a single non-wage amenity is shown on the horizontal axis. This non-wage amenity may be
any one of several positive jobs attributes, for example, the monetary value of fringe benefits, the
probability of not being injured on the job, the advantages associated with job’s location etc.
Let us suppose that the particular non-wage amenity measured left to right on the horizontal axis
is the degree of job safety (the probability of not being injured on the job). Each indifference
curve shows the various combinations of wages and degrees of job safety, which will yield some
given level of utility or satisfaction to this worker. Recall from earlier discussions that each point
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on a specific indifference curve is equally satisfactory, but that total utility can be increased by
getting to a higher indifference curve, that is, by moving northeasterly from I1 to I2 to I3.
Wage Wage
𝐼3
𝐼2
𝐼3
𝐼1
𝐼2
𝐼1
Non-wage amenities Non-wage amenities
𝐹𝑖𝑔. (𝑎) 𝐹𝑖𝑔. (𝑏)
Notice that the indifference curves in panel (a) of the above figure are steep, implying that this
individual is highly averse to risks. To understand this conclusion, observe curve 𝐼1 and notice
that this person places a high substitution value on extra degrees of job safety. A very large
increase in the wage rate is necessary to compensate him or her for a small reduction in safety
(small increase in the probability of job injury). However, indifference maps vary from person
to person; another worker may be far less averse to risk and therefore will have indifference
curves which are relatively flat (panel b) compared to those shown in panel (a) of the same
figure. Therefore, workers are heterogeneous with respect to their preferences for non-wage
amenities.
b) The Employer’s Isoprofit Curves
It is reasonable to assume that an employer can take actions to reduce the probability of job
injury or, alternatively stated, to increase the safety of the workplace. For example, the employer
might provide education programs about job safety, purchase safer machinery, provide protective
work gear, or slow the pace of work. However, because these steps are costly, it is easy to see
that the employer faces a trade-off between the wages offered and the degree of job safety
provided to workers. To maintain any given level of profits, the firm can either (i) pay lower
wages and provide a high degree of job safety, or (ii) pay higher wages and take fewer actions to
reduce the risk of job related accidents.
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Figure (a) and (b) below shows a family of isoprofit curves, each one of which shows the various
combinations of wage rates and degrees of job safety, which yield a given level of profits.
Wage Wage
𝜋1 𝜋1
𝜋2 𝜋2
𝜋3 𝜋3
Non-wage amenities Non-wage amenities
𝐹𝑖𝑔. (𝑎) 𝐹𝑖𝑔. (𝑏)
Curve 𝜋1 is illustrative of the employer’s tradeoff. The concave shape of this isoprofit curve
derives from the realistic assumption that each unit of added job safety comes at increasing
expense, and therefore results in a successively larger wage reduction. Stated alternatively,
successive units of expense (wage reduction) yield diminishing returns to job safety. Marginal
costs typically rise as more job safety is produced. Hence, as one moves rightward on 𝜋1 the
curve becomes increasingly steep.
However, not all employers have identical isoprofit maps; they too are heterogeneous. The
isoprofit curves in panel (a) are relatively flat, indicating that this firm can purchase job safety at
a relatively low incremental cost. Note from 𝜋1 that large increments of job safety are associated
with only small reductions in the wage. Nevertheless, other firms may not be so fortunate. Their
technological constraints may make it extremely difficult to reduce the risk of accident and
therefore will make it very costly to produce a safe work environment. These firms would face
steep isoprofit curves (see panel b). Irrespective of the flatness or steepness of their isoprofit
cures, firms desire to move southwesterly (toward the origin) on their isoprofit maps. The
reason, of course, is that just as northeasterly indifference curves indicate higher levels of total
profit for workers, ear successive isoprofit curve closer to the origin represents a higher level of
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total profit. This is the case because less is being spent on wages and the non-wage amenity.
Competition, however, will dictate a specific isoprofit curve among the many.
For example, suppose that this competitive firm finds itself temporarily on curve 𝜋3 but that
curve 𝜋2 represents a normal (zero economic) profit. The above normal profit at 𝜋3 will attract
new entrants to the industry and thereby increase product supply. This, in turn, will lower the
product price and decrease the firm’s profit to a normal one (𝜋2 ). On the other hand, the firm is
incurring an economic loss when it is on 𝜋1 . As a result, firms will leave the industry until the
remaining firms have isoprofit curves such as 𝜋2 . To conclude, although a competitive firm
indeed faces a family of isoprofit curves, in the long run the zero-economic profit curve is the
relevant one for its decision making with regard to wage amenities (probability of injury).
The Hedonic Wage Function: Different firms have different isoprofit curves and different
workers have different indifference curves. The labour market marries workers who dislike risk
(such as worker 1) with firms that find it easy to provide a safe environment (like firm 1); and
workers who do not mind risk as much (worker 3) with firms that find it difficult to provide a
safe environment (firm 3). The observed relationship between wages and job characteristics is
called a hedonic wage function.
Wage 𝜋3
𝐼3
Hedonic Wage Function

𝐼2 𝜋2
𝐼1 𝜋1
Probability of Injury
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4.2.2.3. Wage Differentials: Labour Market Imperfections

Wage differences can be explained largely-but not fully on the basis of heterogeneous jobs,
employers, and workers. Wage differences also occur because of labour market imperfections,
which impede labour mobility. Such factors as (i) imperfect information, (ii) Costly migration,
and various other barriers to mobility interact to create and maintain wage differentials.
(i) Imperfect Labour Market Information
Labour market information was assumed to be perfect but in reality it is imperfect and costly to
obtain. Recognizing that workers are heterogeneous, firms search the labour market to find
workers who are best suited for employment. Similarly, workers attempt to gather information
about prospective job opportunities by writing letters, inquiring at business establishments, and
so forth. These search efforts by firms and prospective employees therefore involve both direct
costs and opportunity costs of time. Furthermore, the activity of gaining information eventually
will yield diminishing returns. Translated into costs, this implies that the marginal cost of
obtaining information will increase as more of it is sought. The fact that information is imperfect
and increasingly costly to obtain has important implications for labour market activity and the
wage structure. Specifically, it implies that a range of wage rates will exist for any given
occupation, independently of compensating differentials.
(ii) Immobilities
Labour immobilities defined simply as impediments to the movement of labour, constitute
another major reason why wage differentials occur and sometimes persist. For convenience, we
will classify these barriers to labour mobility as geographic, institutional, and sociological.
(a) Geographic immobilities
Wage differences between geographic areas provide an incentive for workers to migrate.
By moving to the high-wage location, a worker can enhance lifetime earnings. But
moving also involves costs for example transportation expenses, forgone earnings during
the move, the inconvenience of adjusting to a new job and community, the negative
aspects of leaving family and friends, and the possible loss of seniority and pension
benefits. If these costs deter migration to the extent that an insufficient number of
migrants are attracted to the higher paying locale, geographic wage differentials will
persist.
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(b) Institutional Immobilities

Restrictions on mobility imposed by such institutions as government and unions may
reinforce immobilites. That is, government licensing of occupation can restrict the
movement of qualified workers among jobs. In addition, differing licensing requirements
in various regions can limit worker mobility geographically. Other institutional
immobilites involve pension plans and seniority rights, which reduce people’s incentive
to move from one job to another.
(c) Sociological immobilities

Finally, there are numerous sociological barriers to labour mobility. In the labour market,
there could be discrimination by race and gender. For example, females appear to be
“crowded” into certain occupations. This drives down the equilibrium wage in these
occupations and raises it elsewhere. Certainly, to the extent that there are barriers which
keep-qualified women from moving from these lower paying positions to higher paying
occupations, wage differentials between the sexes can persist.
4.3. Minimum Wage Laws

Minimum wages are price floors in the labor market. A minimum wage law states that no worker
can be paid less than the minimum wage. Generally, minimum wage laws in the United States
specify some exceptions to the law. Some workers in “uncovered” sectors are not subject to the
minimum wage laws. Most workers are in the “covered” sector and must be paid at least the
minimum wage. Minimum wages laws are set by all levels of government. The federal
government set a minimum wage. Some states and city governments (mainly large cities and
states where the cost of living is higher) set their own, higher, minimum wages. Some cities have
passed “living wage” laws, which set even higher minimum wages.
The following figure graphs a minimum wage law in a basic labor supply and demand graph.
The minimum wage is set at 𝑊, which is above the equilibrium wage level of 𝑊 ∗ . A minimum
wage set below the equilibrium wage would have no effect. The minimum wage reduces
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equilibrium labor hours employed from H ∗ to L𝐷 . This reduction in employment because of the
minimum wage is often called the employment effect.
Wage rate
𝑳𝒔
𝐖
𝐖∗
𝑳𝑫
𝐋𝐃 𝐇∗ 𝐋𝐒 Quantity of Labor
Review Questions
1. Suppose that the demand for burger flippers at fast-food restaurants in a small city is 𝐿 𝐷 =
300 – 20𝑊, where L = the number of burger flippers and W = the wage in dollars per hour. The
equilibrium wage is $4 per hour, but the government puts in place a minimum wage of $5 per
hour.
a. How does the minimum wage affect employment in these fast-food restaurants? Estimate
the effects on employment in the fast-food sector.
b. Suppose that in the city above, there is an uncovered sector where 𝐿𝑆 = −100 + 80𝑊
and 𝐿 𝐷 = 300 – 20𝑊, before the minimum wage is put in place. Suppose that all the
workers who lose their jobs as burger flippers due to the introduction of the minimum
wage seek work in the uncovered sector. What happens to wages and employment in that
sector? Analyze the effects on both wages and employment in the uncovered sector.
2. Suppose that the supply curve for lifeguards is 𝐿𝑆 = 20, and the demand curve for lifeguards
is 𝐿 𝐷 = 100 – 20𝑊 , where L = the number of lifeguards and W = the hourly wage. Now,
suppose that the government imposes a tax of $1 per hour per worker on companies hiring
lifeguards. How will this tax affect the wage of lifeguards and the number employed as
lifeguards?
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3. The demand curve for gardeners is 𝐿 𝐷 = 19 – 𝑊, where L = the number of gardeners, and
𝑊 = the hourly wage. The supply curve is 𝐿𝑆 = 4 + 2𝑊.
a. What is the equilibrium wage and equilibrium number of gardeners hired?
b. Suppose the town government imposes a $2 per hour tax on all gardeners. Indicate the
effect of the tax on the market for gardeners. What is the effect on the equilibrium wage
and the equilibrium number of gardeners hired? How much does the gardener receive?
How much does the customer pay? How much does the government receive as tax
revenue?
4. A researcher estimates the following wage equation for underwater construction workers:
W𝑖 = 10 + 0.5D, where W = the wage in dollars per hour and D = the depth underwater at
which workers work, in meters. A works at a depth of 3 meters, and B works at 5 meters. At their
current wages and depths, what is the trade-off (keeping utility constant) between hourly wages
and a 1-meter change in depth that each worker is willing to make? Which worker has a greater
willingness to pay for reduced depth at 3 meters of depth?
5. Thomas’s utility function is = √𝑌 , where 𝑌 = annual income. He has two job offers. One is
in an industry in which there are no layoffs and the annual pay is $40,000. In the other industry,
there is uncertainty about layoffs. Half the years are bad years, and layoffs push Thomas’s
annual pay down to $22,500. The other years are good years. How much must Thomas earn in
the good years in this job to compensate him for the high risk of layoffs?
6. The demand for labor in Occupation A is 𝐿𝐷 = 20 − 𝑊, where LD = number of workers
demanded for that occupation, in thousands. The supply of labor for Occupation A is 𝐿𝐴 =
−1.25 + 0.5𝑊. For Occupation B, the demand for labor is similar, but the supply of labor is
𝐿𝐵 = −0.5 + 0.6𝑊, which is indicative of a more pleasant environment associated with that
occupation in comparison with Occupation A. What is the compensating wage differential
between the two occupations?
7. The zero-profit isoprofit curve for Company ABC is 𝑊 = 4 + 0.5𝑅, where 𝑊 = the wage
rate that the firm will offer at particular risk levels, R, keeping profits at zero. The zero-profit
isoprofit curve for Company XY is 𝑊 = 3 + 0.75𝑅.
a. At what risk level will the firms offer the same wage?
b. At low-risk levels, which firm will be preferred by workers? At high-risk levels, which
firm will be preferred by workers? Explain.
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CHAPTER FIVE: LABOR MARKET

A labor market is where some unit of labor is bought and sold. Labor is a good with a price
called the wage. For each kind of labor, there is a market. A market may have geographic
dimensions. The labor market for doctors in Ethiopia may be a separate labor market from the
labor market for doctors in the United States.
Labor market comprises four participants: workers, firms, government, and unions. Workers
supply labor. Workers are the employees of firms. Workers make decisions about whether to
work and how much to work. Workers receive wages for their work, which they use to purchase
consumer goods. Firms demand labor. Firms are the employers of workers. Firms combine labor
with other inputs to produce output goods. Firms can be one person (the worker is self-
employed) or very large with thousands of employees. Various levels of government (local, state,
federal) enforce laws which regulate wages (e.g. minimum wage laws) and working conditions.
The government also taxes wages and subsidizes individuals who do not or cannot work. Unions
are groups of workers who collectively bargain labor contracts with employers. Usually unions
are formed among workers in the same industry or occupation.
4.1. Arbitrage across Labor Markets
What we described above is the process by which a single labor market reaches an equilibrium
point. Now, let us consider what happens to the equilibrium point in two separate labor markets.
Consider two geographically separated labor markets. One is the United State labor market and
the other is the Chinese labor market. Chinese Labor Market: the supply of labor in China (from
Chinese workers) and demand for labor in China (from Chinese firms) yields an equilibrium
∗ ∗
wage rate in China of 𝑊𝑐ℎ and equilibrium number of labor hours in China of 𝐻𝑐ℎ . Similarly,
United States Labor Market: the supply of labor in United States (from US workers) and demand
∗
for labor in the US (from US firms) yields an equilibrium wage rate in the US of 𝑊𝑢𝑠 and
∗
equilibrium number of labor hours in the US of 𝐻𝑢𝑠 . Assume that the US equilibrium wage rate
is higher than the Chinese wage rate:
∗ ∗
𝑊𝑢𝑠 > 𝑊𝑐ℎ
What do workers and firms do in each country?
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Firms: because wage rates are lower in China, US firms have an incentive to move to China and
produce their goods in China. As US firms move to China, the labor demand for Chinese
workers increases (a shift out of the Chinese labor demand curve). This produces an increase in
the equilibrium Chinese wage rate.
Workers: because wage rates are higher in the US, Chinese workers have an incentive to
emigrate to the United States and work in the US. As Chinese workers emigrate to the US, the
labor supply of US resident workers (immigrants and natives) increases (a shift out of the US
labor supply curve). This produces a decrease in the equilibrium US wage rate.
Arbitrage: This movement of workers to higher wage labor markets (from China to the US) and
firms to lower wage labor markets (from US to China) causes the equilibrium wage rates in the
two countries to converge. This general process is often called arbitrage. If the arbitrage is
complete, the wage rate in China and the wage rate in the US will be equal:
∗ ∗
𝑊𝑢𝑠 = 𝑊𝑐ℎ
Although these two labor markets are geographically separated, the mobility of firms and
workers implies that the labor demand and supply in each labor market interact and affect each
country’s respective equilibrium wage rate.
5.1.1. Arbitrage across Skill Levels
Consider another example. There are two types of labor defined by the level of skill. One type of
labor is college educated labor provided by workers with a college degree. The other type of
labor is non-college educated labor provided by workers who do not have a college degree. The
two types of labor work in the same geographic area (e.g. same city), but for each type of labor
there is a separate labor market.
Labor Market for College Education Workers: the supply of college educated labor (from
college graduates) and the demand for college-educated labor (from firms that employ college
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educated labor) yields an equilibrium wage rate for college educated labor of Wc∗ and equilibrium
number of college educated labor hours Hc∗.
Labor Market for Non-College Educated Workers: The supply of non-college educated labor
(from workers who do not have a college degree) and the demand for non-college educated labor
(from firms that employ non-college educated labor) yields an equilibrium wage rate for non-
∗ ∗
college educated labor of Wnc and equilibrium number of non-college educated labor hours Hnc .
Assume (as is the case in reality) that the equilibrium wage rate for college educated labor is
higher than the wage rate for non-college educated labor:
Wc∗ > Wnc

∗
What do workers and firms in each labor market do?
Firms: because college educated labor is more expensive relative to non-college educated labor,
firms have an incentive to substitute non-college educated labor for college education labor. This
reduces the demand for college-educated labor (a shift in of the demand curve in this market) and
increases the demand for non-college educated labor (a shift out of the demand curve in this
market). This shift in demand decreases the college educated wage rate and increases the non-
college educated wage rate.
Workers: because the wage rate is higher for college educated workers, there is an incentive for
non-college educated individuals to attend college and become college educated workers (i.e.
enter the college educated labor market). This shifts the supply curve of college educated
workers out and shifts in the supply curve of non-college educated workers. This shift in of
supply decreases the college educated wage rate and increases the non-college educated wage
rate.
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Arbitrage: this movement of workers to higher wage occupations (from non-educated to

educated) and firms to lower wage labor (from educated to non-educated) causes the equilibrium
wage rates in the two labor markets to converge. If the arbitrage is complete, the wage rate for
both types of labor will be equal:
Wc∗ = Wnc
∗
5.2. Labor Market Frictions

In reality, the wage rate has not fully converged in either example. The wage rate in China and
the United States is not equal and college graduates are paid more than non-college graduates
are.
Labor market frictions are the explanations for the failure of wage rates to converge across all
labor markets. A labor market friction is some cost to arbitrage across labor markets. If there are
no labor market frictions, we would expect the wage rate to be the same across all labor markets.
5.2.1. Types of Labor Market Frictions

i. Mobility Costs
These are the costs of physically moving production to a new location (the costs of moving a US
firm to China) or the costs of workers moving to a new labor market (the costs for Chinese
workers emigrating to the US). For some firms, such as those in manufacturing, the cost of
moving to a new labor market is relatively small. For other firms, such as firms in service
industries, these costs are relatively larger. It would be prohibitively costly for my local grocery
store to move to China, use cheaper Chinese labor, and ship my groceries back to me in the US.
However, we have recently seen that some services, such as telemarketing or phone help, are
being “out-sourced” to countries like India where labor costs are lower.
ii. Search Costs

These are the costs borne by firms in finding new workers or the costs borne by workers in
finding new employers. There are some costs incurred during the process of searching for a good
match between employers and employees. For workers, search costs can include the costs of
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walking around and interviewing at different jobs. For firms, the costs can include the costs of
using employment agencies, headhunters, and interviewing and screening job applicants.
iii. Cost of Human Capital Investment

Both firms and workers may need to pay for the cost of new human capital as firms and workers
enter new labor markets. For example, US firms moving to China may have to invest in training
their new Chinese workers. Chinese workers moving to the US will incur some costs in learning
English or other new skills. Workers who want to move from the non-college educated labor
market to the college educated labor market incur the costs of time and tuition in obtaining a
college degree.
Some forms of human capital are impossible to obtain because the human capital stems from
skills or talents an individual is born with. The costs for workers to acquire these skills if they are
not born with them are prohibitively high. For example, professional basketball players earn
much more than I do and I would like to move into their labor market. However, I was not born 7
feet tall or with any athletic ability. The cost for me to obtain these types of human capital and
enter the professional basketball labor market is essentially infinity.
iv. Institutional Rules

There may also be a number of institutional rules, which create labor market frictions and
increase the cost of arbitrage across labor markets. Many governments have explicit rules that
impose costs on firms looking to move to new labor markets or hire or fire workers. If there is a
government rule that states a firm must pay a severance package to laid off workers or contribute
to an unemployment insurance fund, this rule imposes costs on firms who would like to replace
their current workers or move to another labor markets. In labor contracts negotiated by unions,
restrictions may be placed on the extent to which a firm can lay off workers or hire new workers.
5.3. Basic Facts about Unions and Labor Market

Unions are collections of workers. There are three main activities of unions: collective
bargaining with employers over employment contracts, providing social services to union
members (e.g. job training), and political lobbying. About 13 percent of workers in the United
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States belong to unions. This is a decline from a peak of about 25 percent in the 1950-70s period.
In Western Europe, far more workers belong to unions, and the unions there are more involved in
politics. The main focus of unions in the United States is collective bargaining. Most union
members are blue collar workers in the construction, manufacturing, and transportation
industries. More recently, unions have increased their membership among public
sector/government employees: police and firefighters, teachers, postal workers. About 40 percent
of public sector employees are union members.
Unions are formed after a majority of workers at firm vote in an election to certify a particular
union as their collective bargaining representative. This gives the union the sole right to bargain
over labor contracts. The union negotiated contracts apply to all workers, regardless of their
individual union membership. In some states, all workers in a unionized firm are required to join
the union. In 22 states, "right-to-work” legislation allows workers to work at a unionized firm
without joining the union. The non-union workers in unionized firms have varying rights to
negotiate their own labor contracts separately with the employer.
What Do Firms and Unions Bargain Over?

Unions and firms can potentially bargain over all aspects of the employment contract, including
i. Wage rates: starting salaries, criteria for salary increases (e.g. cost of living adjustments),
overtime pay.
ii. Benefits: pension and health insurance.
iii. Rules regarding hiring, both the numbers of new hires and the selection criteria for hiring.
iv. Rules regarding promotion within the firm.
v. Rules regarding firing and layoffs; what are grounds for dismissal; and who gets laid off first.
vi. Level and types of training workers receive from the firm.
vii. Work and safety conditions.
5.3.1. Collective Bargaining

The process of collective bargaining over labor contracts can take several forms.
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i) Agreement: The employer and the union representatives come to an agreement regarding the
labor contract. Depending on the union rules, the labor contract may need to be approved by a
vote of the union membership.
ii) Mediation: if the employer and the union representatives cannot come to an agreement, some
sort of mediation may be used. This can take the form of formalized arbitration in which an
independent, and hopefully objective, individual (an arbitrator) helps the employer and union
representation reach a compromise labor contract. Prior to the start of negotiations, the employer
and union representative may agree to some form of arbitration which will take place if the
parties cannot come to an agreement on their own. If the employer and union agree to binding
arbitration, the ruling of the arbitrator must be abided by the employer and union.
iii) Strikes and Lockouts: if an agreement on a labor contract cannot be reached, the workers
may strike and withhold all labor services. Likewise, the employer can lockout the workers, shut
down production, and withhold all employment. Often, workers are simultaneously on strike and
are locked out by employers. The difference is trivial.
Both sides lose from either a strike or lockout. Workers lose wages and firms lose profits. Strikes
and lockouts can also be quite costly to society if production of some valuable good or service is
stopped (e.g. police officer on strike).
The threat of a strike or lockout is used as a negotiating tactic to secure a better contract for one
of the sides. Although strikes and lockouts often receive considerable media attention (e.g.
hockey or baseball players strikes), very few labor disputes end in a strike or lockout. This is
likely due to the considerable cost to both sides from a strike or lockout. In addition, many states
prohibit public sector employees from striking and instead force some sort of binding arbitration.
What Do Unions Want?
The objective of unions can vary according to their leadership and membership. Some potential
objectives:
1) Some unions may favor higher wages and benefits over higher employment.
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2) Other unions may favor spreading out jobs and work hours among a large number of
employees in exchange for lower wages.
3) Still other unions may sacrifice health and pension benefits to avoid layoffs.
4) Other unions' value compressing the wage structure to ensure that all workers, regardless of
seniority or skill, receive similar wages.
5.4. Principal Agent Problems in Labor Markets
In the model presented so far, the labor market involves a simple transaction. Workers sell an
hour of their time for an hourly wage. In this model, the market exchange is not very different
from a farmer selling a bushel of wheat. A more realistic model of the labor market would
recognize that the employment relationship is more complex. The primary factor influencing the
complexity of labor market arrangements is the presence of principal-agent problems.
A principal-agent problem is a term used in economics for conflicts that arise between two
economic actors. In the case of labor markets, the principal is the owner or owners of the firm.
The agent are the workers that the firm employees. (Note: There could be multiple principal-
agent problems within a firm as managers are agents for owners and the managers are also the
principal for the workers they supervise).
The root of the principal-agent problem is that the principal and agent have different objectives.
The firm (principal) wants the worker (agent) to work as hard as possible at her job, but workers
prefer lower effort. There are four basic characteristics of principal agent problems in a labor
market.
1) Workers can decide to provide various amounts of effort on their jobs
This assumption implies that the worker is not selling the firm a homogenous good (a labor
hour). A worker who is not working hard is often referred to as shirking.
2) Effort is not costless for workers
Workers do not like effort and would prefer low effort. If effort were costless, then there would
be no principal-agent problem, as all workers would provide the maximum effort.
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3) A worker’s effort is not perfectly observed by the firm

This assumption often arises because there is some monitoring cost to observing exactly how
much effort a worker is providing. For example, it would be prohibitively costly for the firm’s
owners to stand next to the worker all day long in order to assess how hard the employee is
working.
Even if there are no monitoring costs, there may be other factors that affect a worker’s observed
output which make it difficult for employers to measure an individual worker’s effort. If workers
work in teams, separating one worker’s contribution from another worker’s is often not possible.
If the effort of teams of workers cannot be separated, workers would have the incentive to free
ride on the contributions of others by reducing their effort.
4) Workers are not full claimants on their effort

This assumption is really the definition of an agent. The worker receives pay from the firm’s
owners, but does not necessarily receive all of the firm’s profits (or losses) that derive from the
worker’s effort. A worker who is a full claimant on her effort would be self-employed, by
definition. Various employment contracts have the goal of making workers nearly full claimants
on their effort. Another way to express this is that many employment contracts try to align as
closely as possible the objectives of the principal and agent by making.
5.5. Internal and External Labor Market
One of the difficulties in hiring employees is that such personal attributes as dependability,
motivation, honesty, and flexibility are difficult to judge from interviews, employment tests, or
even the recommendations of former employers. This difficulty has led many larger firms to
create an internal labor market, in which workers are hired into relatively low-level jobs and
higher-level jobs are filled only from within the firm. This policy gives employers a chance to
observe actual productive characteristics of the employees hired, and this information is then
used to determine who stays with the firm and how fast and how high employees are promoted.
The benefits of using an internal labor market to fill vacancies are that the firm knows a lot about
the people working for it. Hiring decisions for upper-level jobs in either the blue-collar or the
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white-collar workforces will thus offer few surprises to the firm. The costs of using the internal
labor market are associated with the restriction of competition for the upper-level jobs to those in
the firm. Those in the firm may not be the best employees available, but they are the only ones
the firm considers for these jobs. Firms most likely to decide that the benefits of using an internal
labor market outweigh the costs are those whose upper-level workers must have a lot of firm-
specific knowledge and training that can best be attained by on-the-job learning over the years.
Firms that pay for training will want to ensure that they obtain employees who can learn quickly
and will remain with them long enough for the training costs to be recouped through the post-
training surplus. For these firms, the internal labor market offers two attractions. First, it allows
the firm to observe workers on the job and thus make better decisions about which workers will
be the recipients of later, perhaps very expensive, and training. Second, the internal labor market
tends to foster an attachment to the firm by its employees. They know that they have an inside
track on upper-level vacancies because outsiders will not be considered. If they quit the firm,
they would lose this privileged position. They are thus motivated to become long-term
employees of the firm.
In nutshells, internal labor markets are those where workers are hired into entry level jobs and
higher levels are filled from within. Wages are determined internally and may be quite free of
market pressure.
External labor markets imply that workers move somewhat fluidly between firms and wages are
determined by some aggregate process where firms do not have significant discretion over wage
setting. It is contrasted with an internal labour market, in which senior posts are filled mainly by
promoting existing employees in lower-grade jobs. The main merits of an external labour market
are that open competition provides a wider choice for senior appointments, and that outsiders
may bring new ideas to an organization. The main merits of internal labour markets are that a
firm is likely to know more about the strengths and weaknesses of existing employees than
outsiders, and that a reputation for internal promotion as its preferred strategy may assist in
recruitment and retention of staff.
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5.6. The Theory of Labor Market Segmentation

Labor market segmentation defined as the historical process whereby political economic forces
encourage the division of the labor market into separate submarkets, or segments, distinguished
by different labor market characteristics and behavioral rules. Segmented labor markets are thus
the outcome of a segmentation process. Segments may cut horizontally across the occupational
hierarchy as well as vertically. It is suggested that present labor market conditions can most
usefully be understood as the outcome of four segmentation processes.
i. Segmentation into Primary and Secondary Markets

The primary and secondary segments, to use the terminology of dual labor market theory, are
differentiated mainly by stability characteristics. Primary jobs require and develop stable
working habits; skills are often acquired on the job; wages are relatively high; and job ladders
exist. Secondary jobs do not require and often discourage stable working habits; wages are low;
turnover is high; and job ladders are few. Secondary jobs are mainly (though not exclusively)
filled by minority workers, women, and youth.
ii. Segmentation within the Primary Sector
Within the primary sector, we see segmentation between what we call "subordinate" and
"independent" primary jobs. Subordinate primary jobs are routinized and encourage personality
characteristics of dependability, discipline, responsiveness to rules and authority, and acceptance
of a firm's goals. Both factory and office jobs are present in this segment. In contrast,
independent primary jobs encourage and require creative, problem solving, self-initiating
characteristics and often have professional standards for work. Voluntary turnover is high and
individual motivation and achievements are highly rewarded.
iii. Segmentation by Race

While minority workers are present in secondary, subordinate primary and independent primary
segments they often face distinct segments within those submarkets. Certain jobs are "race-
typed", segregated by prejudice and by labor market institutions. Geographic separation plays an
important role in maintaining divisions between race segments.
iv. Segmentation by Sex
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Certain jobs have generally been restricted to men; others to women. Wages in the female
segment are usually lower than in comparable male jobs; female jobs often require and
encourage a serving mentality - an orientation toward providing services to other people and
particularly to men. These characteristics are encouraged by family and schooling institutions.
Labour market segmentation: In essence, neo-classical economic theory sees a market for labour,
with buyers and sellers in open competition with each other, which functions in broadly the same
way as other markets. There are differences of course. It is recognized that labour is not a
completely homogeneous commodity: workers differ in their tastes and preferences for leisure
rather than work and for monetary rather than non-monetary rewards; they differ in human
capital, their investment in education and training, work skills, and experience. However, it still
makes sense to analyze labor supply and demand taken together.
This model of the labour market has been refined over the years to accommodate the fact that
doctors and dress designers, for example, work in entirely different markets. The British
economist Alfred Marshall first introduced the idea of non-competing groups in the labour-
market in the 1880s. The most significant dividing-lines have been identified as occupational,
geographical, and industrial. Occupational labour-markets arise from the division of labour,
increasing differentiation and specialization, with workers unable to switch between occupations
requiring significantly different skills and extensive investment in training and qualifications.
Nurses and doctors, for example, constitute separate occupational labour-markets, even if they
work side by side in the same organizations. By restricting entry to an occupation, for example
by specifying the minimum qualifications and experience required, those already in it can control
the supply of labour and help to push up their wages.
Labour markets are also defined spatially, given that neither employers nor workers can move to
another location without incurring substantial costs. As a result, wages can remain high in big
cities, for example, even when there are substantial numbers of unemployed in other parts of the
country. The term ‘local labour-market’ is often used in reference to the market for jobs within a
particular locale—such as a travel-to-work area, town, or city. Industrial labour-markets arise
where employers in certain industries require particular skills, or combinations of skill, and seek
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to retain workers long-term after they have been trained. For example, police officers, civil
servants, and coal-miners may be mobile across regions of the country and even employers,
while exercising the same range of skills in their work, and obtaining similar or industry-
standard terms of employment.
The idea of non-competing groups has been developed much further in theories that are
identified under the general label of labour-market segmentation theory. The two key
formulations are dual (or split) labour-market theory and internal labour-market theory, both
developed in the United States by Peter Doeringer and and Michael Piore.
5.6.1. Dual Labour Market Theory

According to this theory, the labour market is composed of self-contained sub-markets or
segments. Segmentation economists argue that ignoring the different identities of these segments
and the constraints they place on the workers makes it impossible to understand the nature of
labour market disadvantage. Basically, the dual approach hypothesizes that a dichotomy has
developed over time between a high-wage primary segment and a low-wage secondary segment.
Working conditions in the primary segment are generally favourable; there is steady employment
and job security, and the rules that govern the organisation of employment are well defined and
equitable. The characteristics of secondary employment, on the other hand, are less favourable.
Work here has little job security and there are high turnover rates. There are few opportunities
for training or advancement and the work tends to be menial and repetitive.
Corresponding to this duality in the characteristics of jobs is a further distinction between

primary (core) and secondary (periphery) industrial sectors. In the core sectors, firms have
monopoly power, production is on a large scale, extensive use is made of capital-intensive
methods of production and there is strong trade union representation. These establishments
operate in national and international product markets. In contrast, employment in the periphery is
located in small firms that employ labour-intensive methods of production, operate in
competitive local product markets and have low levels of unionization. Although they are not
entirely coincidental, there is a considerable overlap between primary jobs and core industries,
on the one hand, and secondary jobs and periphery industries on the other.
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Theorists differ in their emphasis on bad jobs in terms of pay and conditions, or on relatively
unskilled work, and on whether the primary and secondary sectors have distinctively different
work cultures. The primary sector generally contains the higher-grade, higher-status, and better-
paid jobs, with employers who offer the best terms and conditions. In some formulations, the
emphasis is on occupational labour markets with controlled entry to them; in others the emphasis
is on industrial labour-markets and the characteristics of employers. The primary sector is
sometimes sub-divided into an upper and lower tier. These economic concepts of primary and
secondary sectors draw on and have close similarities with sociological theory on social
stratification and social mobility between classes. Similarly, the theory of internal labour markets
has close parallels in sociological debates on the Balkanization of labour-markets, industrial
feudalism, and the question of property rights in a job. Labour-market segmentation theory has
been more accessible to sociologists than most classical economic theory.
5.6.2. Internal Labour Markets

The internal labour market is an administrative unit, such as an office or factory, where the levels
of employment and wages are determined by a set of internal administrative rules and
procedures. It is quite separate from the external labour-market of conventional economic theory,
where pricing, allocating, and training decisions are controlled by economic variables. The two
markets are connected, with movement between them at specified ports of entry and exit.
Otherwise, the promotion or transfer of workers who have already gained entry fills jobs in the
internal market. Jobs in the internal market are shielded from the direct influences of competitive
forces in the external market. Another formulation of this perspective is insider—outsider
analysis, which identifies the wage advantage attached to certain labour-market positions, types
of employer, or industry.
Jobs in the primary internal segment are those typical of the hard core of stable employees in a
firm, need long on-the-job training in firm-specific skills, have security and good promotion
prospects, a high span of discretion, and high material rewards. Professional and skilled craft
work requiring occupation-specific rather than firm-specific skills, and often supplied on a
contract or self-employed basis, would be typical of the primary external segment. The
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secondary external segment provides jobs that are low skilled, offer little autonomy and
responsibility, low and unstable earnings, and poor working conditions, including casual and
seasonal work. The secondary internal sector offers jobs that are generally low grade but with
some on-the-job training, security, and promotion prospects. The model makes it clear that
movement between the primary internal and secondary external segments would be virtually
ruled out, with varying amounts and directions of movement between adjacent segments,
determined by changes in human capital and employers' responses to the changing economic
environment.
The concepts of primary and secondary labour-markets (or sectors) have now passed into
conventional thought, with the primary labour-market commonly understood to mean people
with secure jobs and good conditions of work in public-sector employment, the large
corporations, and highly unionized industries. While the secondary labour-market is understood
to cover small employers, non-unionized sectors of the economy, and highly fragmented and
competitive industries such as retailing, where jobs are less secure and conditions of work and
pay generally poorest.
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CHAPTER SIX: HUMAN CAPITAL DEVELOPMENT

Human capital is capital embodied in people. Like physical capital (e.g. machines, tools), human
capital also makes labor more productive. In general, individuals with more human capital
receive higher wages. The level of human capital in the population is a major reasons why wages
differ in the population. The major sources of human capital are formal schooling, on-the-job
training, and experience. However, there are many other types of human capital investments.
Investments in health can be considered investments in human capital as healthy people are more
productive. Another major source of human capital is the abilities and talents individuals are
born with. The time and resources that parents spend caring for and raising their children can
also be considered investments in their children’s human capital.
The level of human capital investments in the population varies widely. This chapter analyzes
why some workers obtain a lot of schooling and other workers drop out at an early age. Workers
who invest in schooling are willing to give up earnings today in return for higher earnings in the
future. For example, we earn a relatively low wage while we attend college or participate in a
formal apprenticeship program. However, we expect to be rewarded by higher earnings later on
as we collect the returns to our investment. The trade-off between the earnings we give up today
while we go to school and the increased earnings in the future, as well as the financial and
institutional constraints that limit access to learning and training opportunities, determines the
distribution of educational attainment in the population. We will initially focus on schooling
because it is a large source of human capital and is relatively easy to measure.
6.1. Human Capital and Productivity

To bridge the labor demand model we discussed earlier with this section on human capital, let’s
assume the productivity of a worker is a function of human capital. Human capital can come
from many different sources, but for simplicity, we can summarize the level of an individual’s
human capital by the variable S. Write the marginal product of each labor hour as a function of
human capital:MPh (S).
Because wages depend on the labor productivity, wages are now a function of human capital:
w(S) = P ∗ MPh (S).
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If we assume that more human capital makes workers more productive,

∂MPh (S)
> 0,
∂S
wages are therefore increasing in human capital:

∂w(S)
>0
∂S
2. 6.2. A Model of Human Capital Investments (The Schooling Model)

Consider a simple model of the decision to attend college. A recent high school graduate has two
choices: she can start work right away or attend college. If she attends college, after 4 years, she
graduates from college and works with a college degree. Assume that if she works without a
college degree, she earns 𝑤𝐻 . If she works with a college degree, she earns 𝑤𝐶 . A reasonable
assumption is that a college graduate earns more than a high school graduate: 𝑤𝐶 > 𝑤𝐻 . This
assumption can be motivated based on the assumption that college makes workers more
productive (college provides more human capital) or because college signals other forms of
unobserved human capital (a signaling model).
If attending college is costless, every person would choose to attend college. However there are
some costs to attending college. One of the costs of obtaining a college degree is that, while the
college student is in school, she cannot work (or at least not work as much if not attending
college). There is an opportunity cost of college attendance from foregone earnings while in
college.
6.2.1. Present Value Calculations

Any study of an investment decision-whether it is an investment in physical or in human capital-
must contrast expenditures and receipts incurred at different time periods. In other words, an
investor must be able to calculate the returns to the investment by comparing the current costs
with the future returns. For reasons that will become obvious momentarily, however, the value of
a dollar received today is not quite the same as the value of a dollar received tomorrow. The
widely used notion of present value allows us to compare dollar amounts spent and received in
different time periods.
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The present value of a payment of, say, Y dollars next year is given by:
Y
PV =
1+r
Where r is the rate of interest, which is also called the rate of discount. The quantity PV tells us
how much needs to be invested today in order to have y dollars next year. In effect, a future
payment of y dollars is discounted so as to make it comparable to current dollars. The discussion
clearly suggests that receiving Y dollars 2 years from now is not equivalent to receiving Y
dollars today or even to receiving Y dollars next year. By arguing along similar lines, we can
conclude that the present value of Y dollars received t years from now equals:
Y
PV =
(1 + r)t
6.2.2. Foregone Earnings and College Attendance

Using the present value framework, we can write the present value of working after high school
and not attending college. We assume a high school graduate earns 𝑤𝐻𝑆 every year she works.
The high school graduate works every year until retirement in period T. Period 𝑡 = 1 is the first
year after high school graduation. The present value of earnings if an individual chooses not to
attend college is
WHS WHS WHS
PVHS = WHS + + 2
+ ⋯+
(1 + r) (1 + r) (1 + r)46
Where r gives the worker's rate of discount. There are 47 terms in this sum, one term for each
year that elapses between the ages of 1 8 and 64.
Assume a college graduate also works every year after college graduation at a wage of 𝑤𝐶𝑂𝐿 . A
college graduate spends the first four years in college and earns no wages during these four
years. The present value of earnings if the individual chooses to attend college is
H H H
PVCOL = −H − − 2
−
(1 + r) (1 + r) (1 + r)3
Direct Costs of Attending College
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WCOL WCOL WCOL

+ 4
+ 5
+ ⋯+
(1 + r) (1 + r) (1 + r)46
Post-college Earnings Stream
The first four terms in this sum give the present value of the direct costs of a college education,
whereas the remaining 43 terms give the present value of lifetime earnings in the post-college
period. We assume that a person's schooling decision maximizes the present value of lifetime
earnings. Therefore, the worker attends college if the present value of lifetime earnings when he
gets a college education exceeds the present value of lifetime earnings when he gets only a high
school diploma, or:
PVCOL > PVHS
Let us illustrate the worker's decision with a simple numerical example. Suppose a worker lives
only two periods and chooses from two schooling options. He can choose not to attend school at
all, in which case he would earn $20,000 in each period. The present value of earnings is:
20,000
PV0 = 20,000 +
(1 + r)
He can also choose to attend school in the first period, incur $5,000 worth of direct schooling
costs, and enter the labor market in the second period earning $47,500. The present value of this
earnings stream is:
47,500
PV1 = −5,000 +
(1 + r)
Suppose that the rate of discount is 5 percent. It is easy to calculate that PV0 = $39,048 and that
PV1 = $40,238. The worker, therefore, chooses to attend school. Note, however, that if the rate
of discount were 15 percent, PV0 = $37,391; PV1 = $36,304, and the worker would not go to
school.
As this example shows, the rate of discount r plays a crucial role in determining whether he
chooses to go to school. The worker goes to school if the rate of discount is 5 percent, but does
not if the rate of discount is 15 percent. The higher the rate of discount, therefore, the less likely
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a worker will invest in education. This conclusion should be easy to understand. A worker who
has a high discount rate attaches a very low value to future earnings opportunities-in other words,
he discounts the receipt of future income "too much." Because the returns to an investment in
education are collected in the far-off future, persons with high discount rates acquire less
schooling.
It is sometimes assumed that the person's rate of discount equals the market rate of interest, the
rate at which funds deposited in financial institutions grow over time. After all, the discounting
of future earnings in the present value calculations arises partly because a dollar received this
year is not equivalent to a dollar received next year.
The rate of discount, however, also depends on how we feel about giving up some of today's
consumption in return for future rewards-or our "time preference." Casual observation (and a
large number of psychological experiments) suggests that people differ in how they approach
this trade-off. Some of us are "present oriented" and some of us are not. Persons who are present
oriented have a high discount rate and would be less likely to invest in schooling. Although there
is some evidence suggesting that poorer families have a higher rate of discount than wealthier
families, we know little about how a person's "time orientation" is determined.
6.2.3. The Wage-Schooling Locus

The simple rule that a person should choose the level of schooling that maximizes the present
value of earnings obviously generalizes to situations when there are more than two schooling
options. The person would then calculate the present value associated with each schooling option
(for example, 1 year of schooling, 2 years of schooling, and so on), and choose the amount of
schooling that maximizes the present value of the earnings stream.
There is, however, a different way of formulating this problem that provides an intuitive
"stopping rule". This stopping rule tells the individual when it is optimal to quit school and enter
the labor market. This alternative approach is useful because it also suggests a way for estimating
the rate of return to education.
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The following figure shows that the wage-schooling locus gives the salary that a particular
worker would earn if he completed a particular level of schooling. If the worker graduates from
high school, he earns $20, 000 annually. If he goes to college for 1 year, he earns $23,000.
Dollars
30,000
25,000
23,000
20,000
12 13 14 18 Years of Schooling
The above figure illustrates the wage-schooling locus, which gives the salary that employers are
willing to pay a particular worker for every level of schooling. If the worker gets a high school
diploma, his annual salary is $20,000; whereas if he gets 18 years of schooling, his annual salary
rises to $30,000. The wage-schooling locus is market determined. In other words, the salary for
each level of schooling is determined by the intersection of the supply of workers with that
particular schooling and the demand for those workers. From the worker's point of view, the
salary associated with each level of schooling is a constant.
The wage-schooling locus shown in Figure above has three important properties.
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1. The wage-schooling locus is upward sloping. More educated workers must earn more as long
as educational decisions are motivated only by financial gains. To attract more educated workers,
employers must compensate those workers for the costs incurred in acquiring an education.
2. The slope of the wage-schooling locus tells us by how much a worker's earnings would
increase if he were to obtain one more year of schooling. The slope of the wage-schooling locus,
therefore, will be closely related to any empirical measure of "the rate of return" to school.
3. The wage-schooling locus is concave. The monetary gains from each additional year of
schooling decline as more schooling is acquired. In other words, the law of diminishing returns
also applies to human capital accumulation. Each additional year of schooling generates less
knowledge and lower earnings than previous years.
6.2.4. The Marginal Rate of Return to Schooling

∆𝑤
The slope of the wage-schooling locus (or ) tells us by how much earnings increase if the
∆𝑆
person stays in school one more year. In the above Figure, for example, the first year of college
increases annual earnings in the post-school period by $3,000. The percentage change in
3,000
earnings from getting this additional year of schooling is 15 percent, (or × 100). In other
20,000
words, the worker gets a 1 5 percent wage increase from staying in school and attending that first
year of college. We define this percentage change in earnings resulting from one more year of
school to be the marginal rate of return to schooling.
The marginal rate of return to schooling gives the percentage increase in earnings per dollar
spent in educational investments. To see why, suppose that the only costs incurred in going to
college are forgone earnings. The high school graduate who delays his entry into the labor
market by 1 year is then giving up $20,000. This investment outlay increases his future earnings
by $3,000 annually, thus yielding an annual 15 percent rate of return for the first year of college.
Because the wage-schooling locus is concave, the marginal rate of return to schooling must
decline as a person gets more schooling. For example, the marginal rate of return to the second
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year of college is only 8.7 percent (a $2,000 return on a $23,000 investment). Each additional
year of schooling generates a smaller salary increase, and it costs more to stay in school. In
effect, the wage increase generated by an additional year of college gets smaller at the same time
that the cost of continuing in school gets higher. The marginal rate of return schedule, therefore,
is a declining function of the level of schooling. The MRR schedule gives the percentage change
in annual earnings resulting from each additional year of school.
6.2.5. The Stopping Rule, or When Should I Quit School?

Suppose that the worker has a rate of discount r that is constant; that is, it is independent of how
much schooling the worker gets. The rate of discount schedule, therefore, is perfectly elastic, as
illustrated in Figure below. Which level of schooling should a person choose? It turns out that
the intersection of the MRR curve and the horizontal rate of discount schedule determines the
optimal level of schooling for the worker, or 𝑠 ∗ years in the figure. In other words, the stopping
rule that tells the worker when he should quit school is given by:
𝑆𝑡𝑜𝑝 𝑠𝑐ℎ𝑜𝑜𝑙𝑖𝑛𝑔 𝑤ℎ𝑒𝑛 𝑡ℎ𝑒 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑡𝑜 𝑠𝑐ℎ𝑜𝑜𝑙𝑖𝑛𝑔 𝑖𝑠 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒, 𝑡ℎ𝑎𝑡 𝑖𝑠,
𝑀𝑅𝑅 = 𝑟.
This stopping rule maximizes the worker's present value of earnings over the life cycle. To see
why, suppose that the worker's rate of discount equals the market rate of interest offered by
financial institutions. Would it be optimal for the worker to quit school after completing only 𝑠′
years in Figure below? If the worker were to stay in school for an additional year, he would
forgo, say, w ′ dollars in earnings, and the rate of return to this investment equals 𝑟′. His
alternative would be to quit school, work, and invest the w ′ dollars in a financial institution that
offers a rate of return of only r. Because education yields a higher rate of return, the worker
maximizes the present value of earnings by continuing in school. Conversely, suppose that the
worker gets more than s' years of school. The following Figure then shows that the marginal rate
of return to this "excess" schooling is less than the market rate of interest, so that the extra years
of schooling are not profitable.
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The stopping rule for schooling investments-describes a general property of optimal investment
decisions. The wealth-maximizing student who must decide if he should quit school faces the
same economic trade-off as the owner of a forest who must decide whether to cut down a tree.
The longer the tree is in the ground, the larger it gets and the more lumber and revenue it
generates. However, there are forgone earnings (as well as maintenance costs) associated with
keeping the tree in the ground. The tree should be cut down when the rate of return on investing
in the tree equals the rate of return on alternative investments.
Rate of
discount
𝐫′
MRR
𝐒′ 𝐒∗ Years of schooling
Why Does Schooling Vary?

The choice of attending college may vary in the population for several reasons:
1) Some people discount the future more than others do. Individuals who value the present
relatively more than the future would choose to work right away rather than waiting until after
college graduation.
2) Some people have higher abilities than others and this affects the relative returns to college
human capital.
3) Some people have a higher taste for schooling than others.
4) Some people are credit constrained and cannot afford to attend college.
5) The returns to college are uncertain and some individuals are more risk averse than others.
These risk averse individuals choose not to invest in this risky asset (the college degree).
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A Numerical Example
Suppose that there are two workers, Willie and Wendy. Willie is particularly adept at "blue
collar" work, and this type of work requires no schooling. Wendy is particularly adept at "white-
collar" work, and this type of work requires 1 year of schooling. Suppose also that there are two
periods in the life cycle. If a person does not go to school, he works in the blue-collar job in both
periods. If the person goes to school, the person would go to school in the first period and work
in the white-collar job in the second period. The wage-schooling locus for each type of worker is
summarized by the data in the following table:
Worker Earnings in Blue-collar job Earnings in White-collar job
Willie $20,000 $40,000
Wendy $15,000 $41, 000
Because Willie is better at doing blue-collar work, he earns more at the blue-collar job ($20,000)
than Wendy would ($1 5,000). Similarly, because Wendy is better at white-collar work, she
earns more in the white-collar job than Willie would. Suppose that both Willie and Wendy have
a discount rate of 10 percent. Each worker calculates the present value of lifetime earnings for
each schooling option, and chooses the one that has the highest present value. The present values
of Willie's alternative earnings streams are:
Willie's present value if he does not go to school
20,000
PVWill = 20,000 + = $38, 181.82
1.1
Willie's present value if he goes to school

40,000
PVWill = 0 + = $36,363
1.1
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Therefore, Willie will decide that he should not go to school and will work in the blue-collar job.
The present values of Wendy's potential earnings streams are:
Wendy's present value if she does not go to school

15,000
PVWen = 15,000 + = $28,636
1.1
Wendy's present value if she goes to school

41,000
PVWen = 0 + = $37,273
1.1
Wendy, therefore, goes to school in the first period and works in a white-collar job in the second.
What data do we observe in the labor market? We observe the earnings of persons who do not go
to school and work in blue-collar jobs (like Willie). The present value of their earnings is
$38,182. We also observe the earnings of persons who do go to school and work in white-collar
jobs (like Wendy). The present value of their earnings stream is $37,273.
A comparison of the two numbers that can be observed would suggest that Wendy made a
terrible mistake. In our numerical example, persons who go to school earn less over their
lifetimes than persons who do not go to school. Because workers sort themselves into particular
occupations, however, this is an irrelevant comparison. Both Willie and Wendy made the right
choice. The problem lies in comparing the earnings of the two types of workers. This comparison
is akin to comparing apples and oranges, and is contaminated by selection bias, the fact that
workers self-select themselves into jobs for which they are best suited.
6.3. Non-Schooling Human Capital

Another major source of human capital is the human capital individuals obtain from work
experience and post-schooling training. We can think of this type of human capital as rather
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heterogenous, as it is often specific to firms, occupations, and industries. Non-schooling human

capital can be informally obtained on-the-job through learning by doing. Or, it can be obtained
more formally through training courses the worker or the firm pay for.
6.4. On-the-Job Training

Training that is provided by firms is called on-the-job training. Firms invest in the human capital
of their workers because it makes the workers more productive. This increase in labor
productivity can in some situations increase the firm’s profits.
6.4.1. Two Types of On-the-Job Training

Firms can make two types of investments in a worker’s human capital.
1) General Human Capital

General human capital is defined as human capital that is productive in more than one firm. For a
welder employed by the automaker GM (her firm), general human capital would be welding
skills the welder could use in many firms and industries.
2) Firm Specific Human Capital

Firm specific human capital is only productive in a given firm. For a welder employed by GM,
firm specific human capital would be the knowledge the welder has in welding together the
unique parts for GM cars. This human capital is not productive in another firm.
We know that firms will generally provide firm specific human capital to their workers.
However, we do not know whether they will also provide general training. The extent to which
firms provide general training to their workers is potentially one of the main determinants of the
stock of human capital in an economy. If firms do not provide general training and workers
cannot finance these investments themselves (e.g. because of credit constraints), there may be a
rationale for government subsidized training.
6.4.2. Will Firms Provide General Training to their Workers?

The answer depends on the structure of the labor market.
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1) Perfectly Competitive Labor Market

If the labor market is competitive, firms will not invest in general skills because workers will
leave after the training. A firm that pays for the general training of their workers makes these
workers more productive with all firms. If the firm does not increase the worker’s wages to
reflect this higher productivity, the worker will leave the current firm and work in another firm.
Even if the firm raises the worker’s wages to reflect the increased productivity, the cost to the
firm of the higher wages completely offsets the benefit to the firm of higher productivity. The
firm therefore has no incentive to invest in general human capital.
In contrast, a firm invests in firm specific skills because these skills are only productive with the
current firm. Workers may still invest in general skills on the job by paying for the training
themselves through lower wages. As an example, apprentices typically are paid less than their
marginal revenue product during the apprenticeship period.
2) Non-Competitive Labor Market

As we discussed earlier, in a non-competitive labor market there are frictions or imperfections in
the labor market, which impose costs on workers moving to another firm. This provides the firm
an incentive to invest in the general skills of their workers since the firm can capture at least part
of the surplus associated with the higher productivity of workers with their current firm relative
to other firms. To illustrate the point, take the extreme case of slavery. Slavery amounts to a
complete labor market friction in which the firm owns the worker, and the worker cannot leave
the employer. In this example, the firm has the incentive to make optimal investments in the
worker’s human capital through general training. Since the worker cannot leave, the firm can
capture the all of the benefits from the investment in the worker’s general human capital.
In general, one can ask why workers continue to make human capital investments throughout
their life cycle. They invest on their human capital due to at least for the following three main
reasons.
1) Human Capital Depreciates
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Just as a physical capital depreciates over time (e.g. tools become dull), human capital may also
depreciate. Many students in this course have at least partially forgotten their high school math
skills. Their accumulated stock of math human capital has depreciated. These students need to
make new investments in math human capital in order to replace this depreciated portion of their
human capital.
2) Returns to human capital change over time

Consider a secretary trained prior to the advent of personal computers in the 1980s. When the
secretary was young in the 1970s, the return to investments in computer skills were low. She
therefore decided not invest in computer human capital. In the 1980s, as personal computer
technology was introduced into the economy, the return to these investments increased. With the
new higher return to investments in computer human capital, the administrative assistant now
chooses to make these investments. The reason she needs to make these investments later in life
is that she could not predict when she was young that the returns to computer human capital
would rise. In this case, technological change creates uncertainty in the returns to human capital
investments. This technological change affects the returns to human capital and causes workers
to make new investments in human capital to update their skills.
3) People update their preferences

When individuals are young, they may have different preferences for education and occupations
than when they get older. An individual when young may have had a strong preference for
engineering and made investments in engineering human capital to work in an engineering
occupation. As the individual got older, her preferences changed and she now has a strong
preference for teaching. Because of this change in preferences, which were not perfectly
predicted in youth, she must now make new investments in teaching human capital later in life.
Review Questions
1. Debbie is about to decide which career path to pursue. She has narrowed her options to two
alternatives. She can become either a marine biologist or a concert pianist. Debbie lives for two
periods. In the first, she gets an education. In the second, she works in the labor market. If
Debbie becomes a marine biologist, she will spend $15,000 on education in the first period and
93 | P a g e
earn $472,000 in the second period. If she becomes a concert pianist, she will spend $40,000 on
education in the first period and then earn $500,000 in the second period.
a. Suppose Debbie can lend and borrow money at a 5 percent annual rate. Which career will she
pursue? What if she can lend and borrow money at a 15 percent rate of interest? Will she choose
a different option? Why?
b. Suppose musical conservatories raise their tuition so that it now costs Debbie $60,000 to
become a concert pianist. What career will Debbie pursue if the discount rate is 5 percent?
2. Peter lives for three periods. He is currently considering three alternative education work
options. He can start working immediately, earning $100,000 in period 1, $110,000 in period 2
(as his work experience leads to higher productivity), and $90,000 in period 3 (as his skills
become obsolete and physical abilities deteriorate). Alternatively, he can spend $50,000 to attend
college in period 1 and then earn $180,000 in periods 2 and 3. Finally, he can receive a doctorate
degree in period 2 after completing his college education in period 1. This last option will cost
him nothing while he is attending graduate school in the second period as his expenses on tuition
and books will be covered by a research assistantship. After receiving his doctorate, he will
become a professor in a business school and earn $40,000 in period 3. Peter's discount rate is 20
percent per period. What education path maximizes Peter's net present value of his lifetime
earnings?
94 | P a g e

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Labour Handout 2

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Prepared By: Timkete A.

CHAPTER ONE: INTRODUCTION TO LABOUR ECONOMICS

1.1. Importance of Labour Economics

1.2. Peculiar Features of Labour and Labour Market

1.3. Interrelationship with other Fields of Economics

Labor economics is both an application of microeconomics theories and macroeconomics

As an application of macroeconomic techniques, labor economics looks at the interaction

1.4. Labour Economics in Historic Perspective

1.5. Unique Features of the Labour Market

(b) Labor is embodied in the seller

Labor as a service to be exchanged in the market is embodied in a human being and is

(c) Heterogeneity of workers and jobs

(d) Multiplicity of markets

CHAPTER TWO: THEORY OF LABOUR SUPPLY

2.1.1. Definition and Types of labour supply Theories

i. The individual utility maximization model (the single person household)

2.1.2. Earnings of Labor

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + Employee benefits (in kind or deferred payment)

2.2. Labor Supply of the Economy

Population of the country

Working age population Population below the working age

Without work, currently available for work,

Shorthand notation of labor force:

Unemployed: An individual is considered unemployed if they are temporarily unemployed (e.g.

2.3. Reservation Wages and the Decision to Work

2.4.1. Utility Maximization

The individual’s optimal or utility-maximizing position can be determined by bringing together

Mathematical Representation of the individual utility maximization problem

The maximization problem:

From this we can write 𝐶 = 5𝐿 − 200

The maximization problem:

Re-written in terms of leisure,

Given the utility function, 𝑀𝑎𝑥𝑈 = 𝑈(𝐶, 𝐿) = 𝐶𝐿

Optimization problem as a Lagrangian function is:

Consumption is increasing in non-labor income. Consumption is decreasing in the price of

The participation decision (reservation) wage is

What is L∗ , H ∗ , and C∗ with p = 2, V = 8, w = 4?

Check to make sure this is feasible: L∗ < 𝑇 and 9 < 16.

Optimal labor supply is

Optimal consumption of consumer goods is

Is the Time Constraint Satisfied?

Is the Tangency Condition Satisfied?

2.5. Labor Supply Elasticity with Respect to Wages

i. Determine optimal leisure demand equation

2.6. Labor Supply Curve

labor supply is simply: 𝑁 ∗ 𝐻𝑖∗ (𝑤, 𝑝, 𝑉).

Wage rate (w)

Hours of leisure (per day) Hours of work

Hours of work (per day)

2.7. The Effect of a Wage Rate Change on the Labor Supply

2.7.4. Graphic Presentation of Income and Substitution effect

From exercise 2 we have the optimal labor supply function

2.9. The Effect of a Standard Workday on Labor Supply

CHAPTER THREE: THEORY OF LABOUR DEMAND

3.1. The objective of the firm

3.2. Derived Demand for Labor

3.2.1. The Demand for Labour in the Short Run

The demand for labour is determined by solving equation (4) in terms of L.

We obtain the supply of output in the short run.

Where, VMP is the value of marginal product

Example: A restaurant owner has the following short-run production function:

3.2.2. The Demand for Labour in the Long Run

Mathematical derivation of Long Run equilibrium