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Whether you have experience waiting on tables, running a cash register, selling clothing, cutting hair, or
managing a Subway franchise, most of you have experience in labor markets. Many of you have worked in
exchange for a wage, to earn money for school or to support yourselves and your families. This experience
should give you an edge in this chapter, since you can apply what you know to the theoretical models described
here.
Wages and salaries account for approximately 75 percent of the national income of the United States.
Despite their importance, wages are just prices. You learned in earlier chapters that prices are determined by the
interaction between demand and supply, and labor markets follow these same basic rules. We will explain how
wages and salaries are determined, and why wages and salaries differ across countries, across populations of
particular countries, and across occupations. Demand and supply factors will both have roles to play in these
explanations.
We will also see that labor markets are unlike markets for final products in interesting ways. Labor is a
“special” commodity; we cannot separate the work from the worker and so issues particular to individuals
sometimes get in the way of market solutions. Thus we must also explore the roles of other important labor
market institutions, unions and discrimination.
After you have read Chapter 13 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Discuss the determinants of the shape and position of the labor demand curve.
2. Use these determinants, along with the perfectly competitive market model, to illustrate wage
dispersion across countries.
3. Describe hours worked, labor force participation, and immigration as important determinants of
labor supply
4. Explain how differences in jobs, differences in people, and a lack of competition can produce wage
differentials across groups.
5. Trace the history of the labor movement in the United States, and show how unions operate to raise
wages and restrict labor supply.
6. Use economic analysis to describe discrimination in labor markets. Apply this analysis to
discrimination against women and against minorities in U.S. labor markets.
7. Review the empirical evidence which documents the significance of labor market discrimination, and
discuss the laws and policies that have been developed to eliminate discrimination from the marketplace.
Match the following terms from column A with their definitions in column B.
A B
__ Real wages 1. When wages rise, workers experience an increase in income. They feel “richer”
and can buy more of all goods, including leisure.
__ Perfectly competitive 2. Education and training that make a worker more productive.
labor markets
__ Compensating 3. The process of negotiation between representatives for firms and workers. for the
differentials purpose of establishing mutually agreeable conditions of employment.
__ Labor supply 4. Wages accruing to Michael Jordan, famous basketball star, that are in excess of
what he could earn at his next-best available occupation.
__ Substitution effect 5. Unions in which workers are grouped on the basis of a particular skill.
__ Income effect 6 A market in which there are large numbers of workers and employers, none of
which has the power to affect wage rates.
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__ Pure economic rent 8. Occurs when individuals are treated on the basis of the average behavior of
members of the group to which they belong.
__ Noncompeting 9. Find it difficult and costly for a member of one profession to enter
groups into the other.
__ Craft unions 10. States that “Employees shall have the right to join labor organizations, to
bargain collectively, and to engage in concerted activities.”
__ Industrial unions 11. Wage differentials that serve to compensate for the relative attractiveness or
nonmonetary differences among jobs.
__ Collective 12. Refers to the number of hours that people desire to work in exchange for a wage.
bargaining
__ National Labor 13. The view that the amount of work to be done in an economy is fixed.
Relations Act
__ Bilateral monopoly 14. When wages rise, workers are tempted to work longer hours. Each hour is now
better paid, making the “price” of taking an hour of leisure higher.
__ Lump-of-labor 15. Occurs when a difference in earnings arises because of an irrelevant personal
fallacy characteristic, such as race, gender, age, or religion.
__ Discrimination 16. Union in which workers are grouped around the entire industry in which they are
employed.
__ Statistical 17. The purchasing power of an hour’s work.
discrimination
Second, labor force participation helps to determine the shape and position of the market supply curve.
Some people may choose not to participate in the labor force but may instead become homemakers or do
volunteer work. Due to technical problems surrounding measurement, economists only count as employed
those who work in exchange for a wage or salary, and only count in the work force those who are employed or
actively seeking work. As the labor force participation rate changes, the shape and position of the market labor
supply curve will change as well.
Third, immigration can have an impact on the market labor supply curve. As people from other countries
have moved into the United States over the course of the century, the labor supply curve has shifted to the
right. Many of these people enter into markets as noncompeting groups; that is, they enter low-skill, low-wage
jobs in neighborhoods populated by people from their home countries. As their job skills and English skills
improve, they have the opportunity to enter a wider range of job markets. Figure l3-l illustrates the initial
impact of the entry of large numbers of immigrants into two different labor markets. Notice that the supply
curve in the less productive labor market shifts to the right, further widening the wage differentials that exist.
Figure 13-1
4. In spite of the fact that the average wage is increasing in the United States, wide wage differentials exist
across groups of workers. This runs counter to the predictions of perfect competition, which describes markets
in which perfect information and a homogeneous product drive all prices in a market to equilibrium.
5. According to economists, wage differentials have three important sources. First, jobs differ in their
attributes and in their attractiveness. Jobs that are particularly unpleasant earn compensating differentials.
This means that supply and demand reflect the utility or “disutility” that workers get from doing particular
tasks. For example, because workers in a nuclear facility have to experience more risk than do workers in many
other jobs, the supply of these workers is lower and wages tend to be higher. This wage differential
compensates individuals for experiencing relatively unpleasant circumstances.
Differences across people also lead to wage dispersion. Innate physical and mental abilities, education
and training, and experience are but a few characteristics that make workers heterogeneous, that is, different
from one another. Labor quality depends upon human capital, the stock of useful and productive knowledge
that workers accumulate during their lifetimes. All of these factors help to explain why some workers earn
more than other workers. For example, the average salary for professional baseball players in the major leagues
is less than $1 million. However, players with star quality sign multimillion-dollar contracts as a return to the
amount of human capital that they have been able to amass.
Finally, the absence of competition in markets can lead to wage dispersion. By “absence of competition”
we mean that markets are often divided into noncompeting groups meaning that it is difficult and costly for a
member of one profession to enter another. For example, although a college economics professor might be a
“doctor of philosophy,” he or she cannot costlessly begin a medical practice tomorrow! As labor markets have
become more and more sophisticated, workers have increasingly specialized in particular production tasks; this
has created large numbers of noncompeting groups due to the fact that it is difficult and expensive, and often
requires lots of training and education, to enter any particular field as a practitioner.
appearance and operation of labor markets. Samuel Gompers was the father of this movement and was the
founder of the American Federation of Labor (AFL), a large group of craft unions. Today, the AFL-CIO
(Congress of Industrial Organizations) exists as a large coalition of craft and industry unions.
2. The main task of unions is to engage employers in collective bargaining, the negotiation process that can
take place between representatives of firms and workers for the purpose of establishing mutually agreeable
conditions of employment. Unions negotiate over compensation issues and also over work rules (job
assignments, tasks, job security, etc.) and procedural features(seniority, layoff policy, dispute resolution, etc.)
of the workplace. Workers were guaranteed the right to collective bargaining in 1935 by the National Labor
Relations Act. This basic right allows employees to work together to improve the conditions of their
employment; without this right, a single worker is often at a disadvantage in bargaining with his or her
employer.
3. Empirical evidence shows that unions have been somewhat successful at increasing the wages of members.
They have achieved this goal most successfully by monopolizing labor supply and controlling entry into
particular occupations.
V. HELPFUL HINTS
1. Notice that the substitution and income effects that influence the labor supply curve are similar to the
substitution and income effects that occur as consumers move along a demand curve. Substitution effects occur
when the price of a product or of leisure rises; consumers substitute toward relatively cheaper goods or work
time. Income effects occur when a consumer has more purchasing power; consumers can buy more of all
goods, including leisure. With both applications, the effects may support one another or may contradict one
another.
2. Human capital is a specific type of productive capital. Workers pursue education and training in order to
raise their value to employers; hence, there are costs and benefits to making an investment in human capital.
Think of this investment in this same way you would think of any other type of capital investments. As
long as the marginal benefit outweighs the marginal cost, the investment project should be undertaken. The
benefits include the extra wages that you will earn over the life of the investment, while the costs include the
payments that you make for tuition, books, fees, etc. Of course, education and training programs bring utility
to workers in ways that cannot always be measured in dollars and cents. However, this dollars-and-cents type
of analysis can be useful in making decisions about human capital investments.
3. Table 13-4 in your textbook is somewhat complex, so it is reproduced here as Table 13-1. As this table
reveals, market wage structures show a great variety of patterns.
Notice that the labor situations have been defined based on two characteristics. First, in a particular market
are workers all alike (homogeneous), or do workers differ in some important ways (heterogeneous)? Second, in
a particular market are jobs all alike, or do they differ based upon some general characteristic of the market?
In case 1, people are homogeneous and jobs are all alike. This is the extreme perfectly competitive
situation, and wages will be equal across all jobs and all workers. In case 2, people are still homogeneous, but
jobs differ in their attractiveness. To make jobs “equal” those jobs that are more unpleasant receive higher wage
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compensation, while those that are more pleasant receive lower wage compensation. The idea here is that wages
adjust until the total utility a worker receives from each job will be about equal, once all job characteristics are
accounted for. Case 3 deals with heterogeneous people separated into noncompeting groups based upon skill,
experience, education, training, or other factors that make an occupation difficult to enter. In this case, wage
differentials are referred to as pure economic rent, which is defined as the excess of wages above the workers’
best available incomes in other occupations. For example, the difference between what Oprah earns as an
entertainer and her wages as, say, an accountant, would be termed pure economic rent. Finally, case 4 deals
with heterogeneous people divided into partially competing groups. This means that there is some limited
mobility between groups, so groups have less monopoly power over occupations. High-wage occupations are
slowly flooded with job applicants, leading to an increase in supply, and thus lower wages. By contrast, low-
wage occupations are slowly abandoned by workers, leading to a decrease in supply, and thus, higher wages.
Once mobility of workers is allowed, even partially, wages have a tendency to move toward some general-
equilibrium level.
4. Your authors state, “The largest group to suffer from economic discrimination is women.” While this may
be true in the United States, and in some particular occupations, discrimination is often based on prejudice, and
so it is generally culturally and socially determined. Therefore, it differs across countries. Think about the
extreme anti-Moslem sentiments displayed in Serbia and Bosnia, and consider the degree of anti-Semitism that
has existed around the world. Both examples describe discrimination based on religious affiliation.
Discrimination against African Americans in the United States has also been significant and is racially
motivated. Age discrimination suits have become more prevalent of late, as the elimination of mandatory
retirement has allowed people to work far beyond age 65. The point is that economic discrimination has
targeted different groups at different times, and it would be wrong to ignore the impact of any of these
instances.
These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.
b. different wages are paid for different jobs in order to compensate for differences in risk.
c. different wages are paid for different jobs because the jobs have different requirements.
d. the wages paid for certain jobs are really payments of economic rent.
e. the excess of one wage rate over another is a compensating differential.
4. Wage differentials exist across countries primarily because of:
a. the existence of international trade agreements between countries.
b. the differing amount of capital that workers have available to them across countries.
c. the differing amount of education and training that workers receive across countries.
d. firms try to discriminate against workers in less-developed countries.
e. both b and c are correct.
5. Determinants of the supply of labor for a given economy include:
a. the size of its population.
b. the rate of participation of its population in the labor force.
c. the standard or legislated length of the workweek.
d. the quality and level of skill embodied in the work force.
e. all the above.
6. The substitution effect, applied to a worker’s decision to change the number of hours worked daily when
offered a different hourly wage, refers specifically to which of the following statements?
a. If the wage offered to workers rises, workers will want to buy better and more costly goods, so each
worker must work longer hours.
b. A general increase in wages tends to produce a general rise in consumer prices that cancels out any real-
income gain for workers.
c. Leisure (nonwork) time is desirable, so a worker’s normal inclination is to choose more leisure in
response to any rise in real income.
d. The cost of working is leisure (nonwork) time sacrificed; hence, if the wage offered to workers falls,
then leisure will become relatively less expensive.
e. Any labor cost increase prompts employers to try to substitute capital for labor in production.
7. Which alternative in question 6 would have been correct had that question referred to the income effect
rather than the substitution effect?
a. If the wage offered to workers rises, workers will want to buy better and more costly goods, so each worker
must work longer hours.
b. A general increase in wages tends to produce a general rise in consumer prices that cancels out any real-
income gain for workers.
c. Leisure (nonwork) time is desirable, so a worker’s normal inclination is to choose more leisure in
response to any rise in real income.
d. The cost of working is leisure (nonwork) time sacrificed; hence, if the wage offered to workers falls,
then leisure will become relatively less expensive.
e. Any labor cost increase prompts employers to try to substitute capital for labor in production.
Figure 13-2
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Figure 13-2 illustrates a backward-bending labor supply curve and four possible demand curves. Use the
diagram to answer questions 8 through 11.
8. If the demand curve changes from position 1 to position 2, then the:
a. substitution effect dominates the income effect.
b. substitution effect and income effect cancel one another out.
c. income effect dominates the substitution effect.
d. income effect and the substitution effect work in the same direction.
e. none of these statements is correct.
9. If the demand curve moves from position 2 to position 3, which alternative in question 8 would be correct?
a. substitution effect dominates the income effect.
b. substitution effect and income effect cancel one another out.
c. income effect dominates the substitution effect.
d. income effect and the substitution effect work in the same direction.
e. none of these statements is correct.
10. If the demand curve moves from position 3 to position 4, which alternative in question 8 would be correct?
a. substitution effect dominates the income effect.
b. substitution effect and income effect cancel one another out.
c. income effect dominates the substitution effect.
d. income effect and the substitution effect work in the same direction.
e. none of these statements is correct.
11. If the demand curve moves from position 4 to position 3, which alternative in question 8 would be correct?
a. substitution effect dominates the income effect.
b. substitution effect and income effect cancel one another out.
c. income effect dominates the substitution effect.
d. income effect and the substitution effect work in the same direction.
e. none of these statements is correct.
12. Empirical evidence on labor supply decisions has shown that the:
a. labor supply curve for adult males is slightly backward-bending.
b. labor supply curve for adult women is slightly backward-bending.
c. labor supply curves for all groups are upward-sloping.
d. wage elasticity of supply for all groups is greater than 1.
e. wage elasticity of supply for all groups is negative.
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Figure 13-3
13. The diagrams in Figure 13-3 show the labor markets of two noncompeting groups. Suppose
antidiscrimination laws lead to the movement of 100 workers from group B to group A. This would cause:
a. daily wages in group A to increase to $50 and daily wages in group B to decrease to $20.
b. daily wages in group A to decrease to $40 and daily wages in group B to increase to $20.
c. daily wages in group B to decrease to $40 while wages in group B remain constant.
d. wages in both groups to remain constant.
e. equalization of wages across these two groups.
14. The concept of noncompeting groups in the labor market is considered useful in explaining:
a. structural unemployment.
b. wage differentials among different categories of labor.
c. the lack of mobility among older workers.
d. the impact on nonunionized sectors of wage increases in unionized sectors of the economy.
e. why wage rates in certain industries have risen faster than the average.
15. The diagrams in Figure 13-4 describe the labor demand curves for two noncompeting groups in the labor
market. If there are 100 workers in market A and 500 workers in market B, daily wages will be:
a. $25 in market A and $5 in market B.
b. $10 in market A and $10 in market B.
c. $20 in market A and $0 in market B.
d. $20 in market A and $10 in market B.
e. none of the above.
Figure 13-4
16. To say that there is an economic-rent element in a person’s income means that:
a. this income comes at least in part from property ownership rather than from the labor supply.
b. this income exceeds what it would be if the labor market were perfectly competitive.
c. if the price offered for this person’s labor were increased, then he or she would want to reduce the
number of daily hours worked.
d. this income is far above average but is the result of some relatively unique natural talent.
e. this person’s labor supply curve is perfectly inelastic with respect to price, at least within some range
of prices, because he or she is somewhat unique.
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17. A person who receives a higher wage than would be necessary as an inducement to work is said to be
receiving:
a. rent.
b. profit.
c. interest.
d. marginal product.
Figure 13-5
The following problems are designed to help you apply the concepts that you learned in this chapter.
Figure 13-6
2. a. The supply of labor has at least three major determinants. List them below:
(1)
(2)
(3)
b. On the basis of the supply and demand curves depicted in Figure 13-7, indicate in the blanks provided
the likely effect on the real wage of each of the following economic adjustments. Denote an increase by
(+), a reduction by (-), and no change by (0).
Figure 13-7
3. Suppose that the hourly wage offered to you rises. Assume that you have some freedom over the number
of hours you choose to work per day or per week. In these circumstances, economic theory predicts that you
might choose to work more, fewer, or the same number of hours per day.
This indicates the opposite and conflicting pulls of the substitution effect and the income effect.
a. When you are offered a higher wage for each hour worked, you are then sacrificing more money income
than before for each hour you do not work; i.e., the opportunity cost of leisure is climbing. The higher
hourly wage is thus an inducement to work (more / fewer) hours per day or week because leisure has
become more expensive. This by itself is the substitution effect. It encourages a worker to give up some
(working hours in favor of leisure / leisure hours in favor of work).
b. Leisure time is (for most people) a desirable thing; as real incomes rise, most folks want more of it.
The offer of a higher hourly wage makes more leisure possible (with / without) the sacrifice of some
income. The pull of the income effect is toward (fewer / more) working hours and correspondingly (fewer
/ more) hours of leisure.
c. For example, suppose that you are working 40 hours weekly given a $6 hourly wage, for a weekly
income of $240. If your wage rises to $10, you could choose to earn $350 per week by working (35 / 40 /
45) hours. If this is the case, the (substitution / income) effect has dominated.
4. There are four panels in Figure 13-8, one for each of the four parts to this question. For each part listed
below, draw a new supply and/or demand curve in the corresponding panel to represent the effect of the change
indicated, and predict the direction that the change will push the real wage and employment. For example, if
one of the parts stated that there is an increase in the supply of labor, then you would draw a new supply curve
to the right of the existing one and predict that wages would fall (-) and employment would climb (+). Record
your predictions in Table 13-2.
a. The job becomes more onerous than usual, and people demand compensation for its additional
burdens.
b. The job becomes extremely specialized, and only 10 people can accomplish the task that it requires.
e. Education and training improve the quality of the labor employed.
d. The job market is suddenly cut in half because of noncompeting discrimination.
Figure 13-8
TABLE 13-2
Effect on Effect on
Part Employment Wages
a. ___ ___
b. ___ ___
c. ___ ___
d. ___ ___
b. Collective bargaining is the process of negotiations between representatives of firms and workers for
the purpose of establishing mutually agreeable conditions of employment. Suppose Figure 13-9 describes
labor market conditions in the newly organized widget industry. Initially, the equilibrium wage rate is
$___ per day and ___ workers are employed in the industry. Suppose the union targets a wage of $45 per
day. This will limit employment to ___ workers and will lead to an excess (demand / supply) of ___
workers in the market.
c. In reality the union may or may not be able to achieve its wage target. A bilateral monopoly situation
arises when (a single union / a group of unions) and (a single buyer / a group of buyers) of labor
negotiate with one another. The result is a topic for game-theoretic research and modeling techniques.
Figure 13-9
Answer the following questions, making sure that you can explain the work you did to arrive at the answers.
1. Table 13-1 in your text lists wages and fringe benefits in Mexico at $2.34 per hour (2001). What kinds of
actions might be taken to shift the labor demand curve to the right in Mexico?
2. Table 13-3 in your text lists average wages per full-time employee in the farming industry at $24,657
(2001). List and explain two factors that might explain low relative wages in this industry.
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Figure 13-10
3. Think about the investment in human capital that you are making by taking this course in economics. List
all of the direct costs, all of the opportunity costs, and then think about what you expect to gain. Is this
investment a profitable one? Explain.
4. Since the mid-1960s, the labor force participation rate of women has risen dramatically, from 40 percent to
almost 60 percent of the population. Your authors state, “A change of this magnitude cannot be explained by
economic factors alone. To understand such a significant alteration in working patterns, one must look outside
the narrow scope of economics—to changing social attitudes toward the role of women as mothers,
homemakers, and workers.”
List and explain three such changes that have occurred over this time period that may have had an impact
on the labor force participation rates of women in the U.S. economy.
5. Immigration policy in the United States has been alive with controversy over the past few years, as people
in border states like California and Florida have become inundated with both legal and illegal immigrants. Use
market models to illustrate the impact of these immigrants on local labor markets. Who gains and who loses
when large numbers of immigrants enter a labor market? On what does this depend?
6. We can use the concept of price elasticity (Chapter 4 in your text and in this Study Guide) to gain some
insights into labor markets and the effects of unionization.
a. Define the concept of price elasticity of demand in labor markets. Suppose you hear that the elasticity
of demand for a particular type of labor is -2.5. How would you interpret this?
b. Define the concept of price elasticity of supply in labor markets. Suppose you hear that the elasticity
of supply for a particular type of labor is .4. How would you interpret this?
c. We learned in this chapter that unions work to increase wages for the workers they represent. Will this
be an easier or less easy task to accomplish if the demand curve for the final product is relatively elastic?
Use a diagram to illustrate your answer.
12 Labor supply
14 Substitution effect
1 Income effect
2 Human capital
4 Pure economic rent
9 Noncompeting groups
5 Craft unions
16 Industrial unions
3 Collective bargaining
10 National Labor Relations Act
7 Bilateral monopoly
13 Lump-of-labor fallacy
15 Discrimination
7 Statistical discrimination
TABLE 13-2
Effect on Effect on
Part Employment Wages Graph
a. - + Supply shifts left
b. - + Supply vertical at 10
c. + + Demand shifts right
d. - + Supply shifts left
5. a. Craft, Industrial
b. $30, 600, 300, supply, 600
c. a single union, a single buyer
6. a. a reduction, $10, $8, diminishing marginal productivity, climb, increased productivity, $15
b. If the curve DHDH were sufficiently inelastic, then the addition of five workers from market B could
lower the wage below $5. All five workers would not move, if that were the case, and the equilibrium
wage in both markets would still exceed $5.
1. Workers might obtain more training and education, increasing their productivity. Firms might find new
markets for their final products, increasing demand for final products and the workers needed to produce output.
2. Markets for farm labor are almost perfectly competitive. Farm employees often need little formal education
and hence have not invested large sums of money in human capital development.
3. Direct costs include the costs of tuition, books, tutoring, childcare expense if you have a family that must
be cared for, and travel to and from school. Opportunity costs account for what you could be earning at the
next-best use of your time. This might be overtime pay if you worked additional hours in the market or it
might be measured by the value of tasks that you would be completing at home, such as laundry, a freshly
painted room, or bedtime stories. You hope to gain increased productivity so that you earn more money in the
marketplace or take more value into any task that you might undertake over the course of your lifetime.
4 a. Improved technology in the household, allowing greater productivity per hour spent.
b. Many Women now have better control over their reproductive lives.
c. Government legislation has provided better access to education and jobs for women.
5. See diagram. Immigrants gain because they often have better job opportunities and higher wages in the
U.S. Employers gain because the price of labor is now lower. Workers who were already in the market lose
because their wages are now lower. Local taxpayers lose if they have to bear the burden of higher welfare costs
brought on by these immigrants.
6. a. Price elasticity of demand in labor markets measures the responsiveness of employers to changes in
wage rates. If the wage elasticity of demand is -2.5, we would say that if wages increase by 10 percent,
then the quantity of labor demanded would fall by 25 percent.
b. Price elasticity of supply in labor markets measures the responsiveness of workers to changes in wage
rates. If the wage elasticity of supply for labor is .4, we would say that if wages increased by 10 percent,
then the quantity of labor supplied would increase by 4 percent.
c. The more inelastic the demand curve for the final product, the easier it is for firms to raise wages. The
more inelastic the demand for the final product, the smaller the buyer response to any change in the price of
the product. Firms can pass cost increases on to consumers more easily.