Table of contents:

1. Introduction-Compensation and measurement 2. Demand for labor and wage determination 2.1 Wage Contracts 2.2 Wage differentials between sexes and races 2.3 Union-nonunion wage differentials 2.4 Skill differentials 2.5 Education and earnings

3. Two ways of analyzing labor markets 4. Neoclassical microeconomics of labor markets

4.1 Neoclassical microeconomic model Supply 4.2 Neoclassical microeconomic model Demand 4.3 Neoclassical microeconomic model Equilibrium

4.4.1 The supply of high-skilled and low-skilled labor 4.4.2 The demand for high-skilled and low-skilled labor 4.4.3 Equilibrium for high-skilled and low-skilled labor 5. Information Approaches 6. Search models 7. Criticisms of labor economics and recent research 8. References

1. Introduction- Compensation and measurement:

Labor economics seeks to understand the functioning and dynamics of the market for labor. Labor markets function through the interaction of workers and employers. Labor economics looks at the suppliers of labor services (workers), the demanders of labor services (employers), and attempts to understand the resulting pattern of wages, employment, and income. In economics, labor is a measure of the work done by human beings. It is conventionally contrasted with such other factors of production as land and capital. There are theories which have developed a concept called human capital (referring to the skills that workers possess, not necessarily their actual work), although there are also counter posing macro-economic system theories that think human capital is a contradiction in terms. Wage is a basic compensation for paid labor, and the compensation for labor per period of time is referred to as the wage rate. Other frequently used terms include: wage = payment per unit of time (typically an hour) earnings = payment accrued over a period (typically a week, a month, or a year)
total compensation = earnings + other benefits for labor income = total compensation + unearned income economic rent = total compensation - opportunity cost

Economists measure labor in terms of hours worked, total wages, or efficiency. total cost = fixed cost + variable cost

2. Demand for labor and wage determination

Labor demand is a derived demand, in other words the employer's cost of production is the wage, in which the business or firm benefits from an increased output or revenue. The determinants of employing the addition to labor depend on the Marginal Revenue Product (MRP) of the worker. The MRP is calculated by multiplying the price of the end product or service by the Marginal Physical Product of the worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker. The firm only employs however up to the point where MRP=MC, not lower, in economic theory. Wage differences exist, particularly in mixed and fully/partly flexible labor markets. For example, the wages of a doctor and a port cleaner, both employed by the NHS, differ greatly. But why? There are many factors concerning this issue. This includes the MRP (see above) of the worker. A doctor's MRP is far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than that of becoming a port cleaner. For example to become a doctor takes a lot of education and training which is costly, and only those who are socially and intellectually advantaged can succeed in such a demanding profession. The port cleaner however requires minimal training. The supply of doctors therefore would be much more inelastic than the supply of port cleaners. The demand would also be inelastic as there is a high demand for doctors, so the NHS will pay higher wage rates to attract the profession. The MRP of the worker is affected by other inputs to production with which the worker can work (e.g. machinery), often aggregated under the term "capital". It is typical in economic models for greater availability of capital for a firm to increase the MRP of the worker, all else equal. The education and training noted in the last paragraph are counted as "human capital". Since the amount of physical capital affects MRP, and since financial capital flows can affect the amount of physical capital available, MRP and thus wages can be affected by financial capital flows within and between countries, and the degree of capital mobility within and between countries. In Marxian economics, the aim of labor economics is to provide insight and guidance for the optimal allocation of cooperative human labor. However, this optimality is not simply viewed as a "technical variable" as in micro-economics, because workers are not simply a "factor of production", but human beings who organize themselves and each other. Forms of labor cooperation can be oppressive, irrational and exploitative, or they can be beneficial, rational, or effective. That is to say, labor economics has a political dimension insofar as different workers and employers have different interests. There is a workers' point of view and an employer's point of view.

2.1 Wage Contracts

One simple type of contract just specifies a wage and then lets the firm choose employment once A is determined; many actual contracts at least appear to take this form. Under such a

contract, unemployment and real wage rigidity arise immediately. A fall in labour demand, for example, causes the firm to reduce employment at the fixed real wage while labour supply does not shift, and thus creates unemployment (or, if all workers work the same amount, underemployment). And the cost of labour does not respond because, by assumption, the real wage is fixed. But this is not a satisfactory explanation of unemployment and real wage rigidity. The difficulty is that this type of a contract is inefficient (Leontief, 1946; Barro 1977; Hall, 1980). Since the wage is fixed and the firm chooses employment taking the wage given, the marginal product of labour is independent of A. But since employment varies with A, the marginal disutility of working depends on A. Thus the marginal product of labour is generally not equal to the marginal disutility of work, and so it is possible to make both parties to the contract better off. And is labour supply is not very elastic, the inefficiency is large. When labour demand is low, for example, the marginal disutility of work is low, and so the firm and the workers could both be made better off if the workers worked slightly more. Thus we can appeal to fixed-wage contracts with employment determined at the firms discretion as a potential explanation of unemployment and real wage rigidity only if we can explain why a firm and its workers would agree to such an arrangement.

2.2 Wage differentials between sexes and races

Earnings differentials between men and women and between whites and minorities arise from differences in types of jobs, discrimination, differences in human capital, and differences in degree of specialization. Well-paid jobs such as those in the legal, medical and other professions and in higher ranks of management are more likely to be held by white men than by women or minorities. Women and minorities are more likely to be discriminated against than white men, but discrimination is hard to measure objectively. Historically, white men have had more human capital than other groups, but human capital differences arising from schooling differences have been declining and have almost been eliminated. Differentials based on work experience have kept womens pay below that for men because womens careers have traditionally been interrupted more frequently than those of men, resulting, on the average, in a smaller accumulation of human capital.

Differentials arising from different degrees of specialization are probably important and might persist. Men have traditionally been more specialized in market activity, on the average, than women. Women have traditionally undertaken both nonmarket activities (household, production and market activities.

2.3 Union-nonunion wage differentials

Wage differentials can arise from labor market monopolies. The main source of these monopolies is the labor union. A labor union is an organized group of workers whose purpose is to increase wages and influence other job conditions for its members. The union seeks to restrict competition, and as a result, increases the price at which labor is traded. There are two main types of union: -Craft unions -Industrial unions. A craft union is a group of workers who have a similar range of skills but work for many different firms in many different industries and regions. Examples are the carpenters union and the electrical workers union (IBEW). An industrial union is a group of workers who have a variety of skills and job types, but work for the same firm or industry. The United Auto Workers and the Steelworkers union are examples of industrial unions. Unions negotiate with employers or their representatives in a process called collective bargaining. The main weapons available to the union and the employer in collective bargaining are the strike and the lockout. A strike is a group decision to refuse to work under prevailing conditions. A lockout is a firms refusal to operate its plant and employ its workers. Each party uses the threat of a strike or a lockout to try to get an agreement in its own favor. Sometimes, when the two parties in the collective bargaining process cannot agree on the wage rate or other conditions of employment, they agree to submit their disagreement to binding arbitration. Binding arbitration is a process in which a third party (an arbitrator) determines wages and other employment conditions on behalf of the negotiating parties.

2.4 Skill differentials

Skill differentials arise partly because high-skilled labor has a higher marginal revenue product than low-skilled labor and partly because skills are costly to acquire. Skills are costly to acquire because households have to invest in human capital to become skilled. Investment sometimes means direct payments such as tuition and other training fees and sometimes means working for a lower wage during on-the-job training. Because skills are costly to acquire, households supply high-skilled labor on turns that compensate them for both the time spent on the job and the costs of acquiring the skills. Thus, the supply curve of high-skilled labor lies above the supply curve of low-skilled labor. Wage rates of high-skilled and low-skilled labor are determined by demand of supply in the two labor markets.

2.5 Education and earnings

There are large and persistent differences in earnings based on the degree of education and training. An indication of those differences can be seen in the graph below. This figure highlights two important sources of earning differences. The first is the degree of education itself. The higher the level of education, other things remaining the same, the higher are a persons earnings. Age is strongly correlated with experience and the degree of on-the-job training a person has had. Thus, a person gets older up to middle age, earnings increase.

Earnings of male employees at various ages and with varying school levels are shown. Earnings increase with length of education and also with age but only up to the middle forties. Beyond that age, earnings decrease. These differences show the importance of experience and education influencing skill differentials.

3. Two ways of analyzing labor markets

There are two sides to labor economics. Labor economics can generally be seen as the application of microeconomic or macroeconomic techniques to the labor market. Microeconomic techniques study the role of individuals and individual firms in the labor market. Macroeconomic techniques look at the interrelations between the labor market, the goods market, the money market, and the foreign trade market. It looks at how these interactions influence macro variables such as employment levels, participation rates, aggregate income and Gross Domestic Product. The labor force is defined as the number of individuals age 16 and over, excluding those in the military, who are either employed or actively looking for work. The participation rate is the number of people in the labor force divided by the size of the adult civilian noninstitutional population (or by the population of working age that is not institutionalized). The nonlabor force includes those who are not looking for work, those who are institutionalized such as in prisons or psychiatric wards, stay-at home spouses, children, and those serving in the military. The unemployment level is defined as the labor force minus the number of people currently employed. The unemployment rate is defined as the level of unemployment divided by the labor force. The employment rate is defined as the number of people currently employed divided by the adult population (or by the population of working age). In these statistics, self-employed people are counted as employed. Variables like employment level, unemployment level, labor force, and unfilled vacancies are called stock variables because they measure a quantity at a point in time. They can be contrasted with flow variables which measure a quantity over a duration of time. Changes in the labor force are due to flow variables such as natural population growth, net immigration, new entrants, and retirements from the labor force. Changes in unemployment depend on: inflows made up of nonemployed people starting to look for jobs and of employed people who lose their jobs and look for new ones; and outflows of people who find new employment and of people who stop looking for employment. When looking at the overall macroeconomy, several types of unemployment have been identified, including: Frictional unemployment this reflects the fact that it takes time for people to find and settle into new jobs. If 12 individuals each take one month before they start a new job, the aggregate unemployment statistics will record this as a single unemployed worker. Technological change often reduces frictional unemployment, for example: the internet made job searches cheaper and more comprehensive. Structural unemployment this reflects a mismatch between the skills and other attributes of the labor force and those demanded by employers. If 4 workers each take six months off to re-train before they start a new job, the aggregate unemployment statistics will record this as two unemployed workers. Technological change often increases structural unemployment, for example: technological change might require workers to re-train.
Natural rate of unemployment this is the summation of frictional and structural

unemployment. It is the lowest rate of unemployment that a stable economy can expect to achieve, seeing as some frictional and structural unemployment is inevitable. Economists do not agree on the natural rate, with estimates ranging from 1% to 5%, or on its meaning some associate it with "non-accelerating inflation". The estimated rate varies from

country to country and from time to time.

Demand deficient unemployment In Keynesian economics, any level of unemployment

beyond the natural rate is most likely due to insufficient demand in the overall economy. During a recession, aggregate expenditure is deficient causing the underutilization of inputs (including labor). Aggregate expenditure (AE) can be increased, according to Keynes, by increasing consumption spending (C), increasing investment spending (I), increasing government spending (G), or increasing the net of exports minus imports (XM). {AE = C + I + G + (XM)}

4. Neoclassical microeconomics of labor markets

Neo-classical economists view the labor market as similar to other markets in that the forces of supply and demand jointly determine price (in this case the wage rate) and quantity (in this case the number of people employed). However, the labor market differs from other markets (like the markets for goods or the money market) in several ways. Perhaps the most important of these differences is the function of supply and demand in setting price and quantity. In markets for goods, if the price is high there is a tendency in the long run for more goods to be produced until the demand is satisfied. With labor, overall supply cannot effectively be manufactured because people have a limited amount of time in the day, and people are not manufactured. The income effect suggests a rise in overall wages will, in many situations, not result in more supply of labor: it may result in less supply of labor as workers take more time off to spend their increased wages. The substitution effect of a higher wage might cause people to work more, as the opportunity cost to work less is greater than it was prior to the increase. While available empirical evidence is mixed, some analysts suggest the income and substitution effects cancel each other out, resulting in no supply increase. Within the overall labor market, particular segments are thought to be subject to more normal rules of supply and demand as workers are likely to change job types in response to differing wage rates. The labor market also acts as a non-clearing market. Whereas most markets have a point of equilibrium without excess surplus or demand, the labor market is expected to have a persistent level of unemployment. Contrasting the labor market to other markets also reveals persistent compensating differentials among similar workers. Many economists have thought that, in the absence of laws or organizations such as unions or large multinational corporations, labor markets can be close to perfectly competitive in the economic sense. The competitive assumption leads to clear conclusions workers earn their marginal product of labor.

4.1 Neoclassical microeconomic model Supply

Households are suppliers of labor. In microeconomics theory, people are assumed rational and seeking to maximize their utility function. In this labor market model, their utility function is determined by the choice between income and leisure. However, they are constrained by the waking hours available to them. Let w denote hourly wage. Let k denote total waking hours. Let L denote working hours. Let denote other incomes or benefits. Let A denote leisure hours. The utility function and budget constraint can be expressed as following: Max U(w L + , A) such that L + A k. If the preference for consumption is measured by the value of income obtained, rather than work hours, this diagram can be used to show a variety of interesting effects. This is because the slope of the budget constraint becomes the wage rate. The point of optimization (point A) reflects the equivalency between the wage rate and the marginal rate of substitution, leisure for income (the slope of the indifference curve).

4.2 Neoclassical microeconomic model Demand

This article has examined the labor supply curve which illustrates at every wage rate the maximum quantity of hours a worker will be willing to supply to the economy per period of time. Economists also need to know the maximum quantity of hours an employer will demand at every wage rate. To understand the quantity of hours demanded per period of time it is necessary to look at product production. That is, labor demand is a derived demand: it is derived from the output levels in the goods market. A firm's labor demand is based on its marginal physical product of labor (MPL). This is defined as the additional output (or physical product) that results from an increase of one unit of labor (or from an infinitesimally small increase in labor). The marginal revenue product of labor can be used as the demand for labor curve for this firm in the short run. In competitive markets, a firm faces a perfectly elastic supply of labor which corresponds with the wage rate and the marginal resource cost of labor (W = S L = MFCL). In imperfect markets, the diagram would have to be adjusted because MFCL would then be equal to the wage rate divided by marginal costs.

4.3 Neoclassical microeconomic model Equilibrium

The demand for labor of this firm can be summed with the demand for labor of all other firms in the economy to obtain the aggregate demand for labor. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtain the aggregate supply of labor. The supply and demand curves can be analyzed in the same way as any other industry demand and supply curves to determine equilibrium wage and employment levels.

4.4 Demand, Supply and Equilibrium of high-skilled and low-skilled labor 4.4.1 The supply of high-skilled and low-skilled labor
Skills are costly to acquire. Furthermore, a worker usually pays the cost of acquiring a skill before benefiting from a higher wage. For example, attending college usually leads to a higher income, but the higher income is not earned until after graduation. These facts imply that the acquisition of a skill is an investment. To emphasize the investment nature of acquiring a skill we call that activity an investment in human capital. Human capital is the accumulated skill and knowledge of human beings. The opportunity cost of acquiring a skill includes actual expenditures on such things as tuition and room and board and also costs in the form of lost or reduced earnings while the skill is being acquired.

4.4.2 The demand for high-skilled and low-skilled labor

High-skilled workers can perform a wide variety of tasks that low-skilled workers would perform badly or perhaps could not even perform at all. Imagine an untrained inexperienced person performing surgery or piloting an airplane. High-skilled workers have a higher marginal revenue product than low-skilled workers. The graph below shows the demand curves for high-skilled and low-skilled labor. At any given level of employment, firms are willing to pay a higher wage rate to a high-skill worker than to a low-skilled worker. The gap between two wage rates measures the marginal revenue product of skill for example at an employment level of 2000 hours, firms are willing to pay 12.50 $ for a high-skilled worker and only 5$ for a low-skilled worker, a difference of 7.50 $ an hour. Thus the marginal revenue product of skill is 7.50 $ an hour.

4.4.3 Equilibrium for high-skilled and low-skilled labor

Part (a) illustrates the marginal revenue product of skill. Low-skill workers have a marginal revenue product that gives rights to the demand curve marked DL. High-skilled workers have a higher marginal revenue product than low-skill workers. Therefore, the demand curve for highskilled workers DH lies to the right of DL. The vertical distance between these two curves is the marginal revenue product of the skill. Part (b) shows the effects of the cost of acquiring skills on the supply curves of labor. The supply curve for low-skills workers is SL. The supply curve for high-skilled workers is SH. The vertical distance between these two curves is the required compensation for the cost of acquiring a skill. Part (c) shows the equilibrium employment and the wage differential. Low-skilled workers earn a wage rate of 5$ an hour and 2000 hours of low-skilled labor are employed. High-skilled workers earn a wage of 10$ and 3000 hours of high-skilled labor are employed. The wage rate for high-skilled workers always exceeds that for low-skilled workers.

5. Information Approaches
Since the 1970s some attention has shifted to the information characteristics of the labour market In the classical model it is assumed that both sides know how much work effort and marginal product the employee contributes. In many real-life situations this is far from the case. The firm does not necessarily know how hard a worker is working or how productive they are. This provides an incentive for workers to shirk from providing their full effort since it is difficult for the employer to identify the hardworking and the shirking employees, there is no incentive to work hard and productivity falls overall.

The methods used to overcome this type of problem have been studied by modern labour economists. One solution used recently (stock options) grants employees the chance to benefit directly from the firm's success. However, this solution has attracted criticism as executives with large stock option packages have been suspected of acting to over-inflate share values to the detriment of the long-run welfare of the firm. Another aspect of uncertainty results from the firm's imperfect knowledge about worker ability. If a firm is unsure about a worker's ability, it pays a wage assuming that the worker's ability is the average of similar workers. This wage undercompensates high ability workers and may drive them away from the labor market. Such phenomenon is called adverse selection and can sometimes lead to market collapse. There are many ways to overcome adverse selection in labor market. One important mechanism is called signaling, pioneered by Michael Spence. In his classical paper on job signaling, Spence showed that even if education does not increase productivity, high ability workers may still acquire it just to signal their abilities. Employers can then use education as a signal to infer worker ability and pay higher wages to better educated workers.

6. Search models
One of the major research achievements of the last 20 years has been the development of a framework with dynamic search, matching, and bargaining. Work started in the early 1980s with contributions from Peter A. Diamond, Dale T. Mortensen and others which characterized equilibrium in such model economies. Later, this framework was tailored to the labor market. More recently, Mortensen and Christopher A. Pissarides have extended the framework to include labor market institutions such as unemployment insurance and employment protection.

7. Criticisms of labor economics and recent research

One critique of standard economic analysis of labor markets is that it does not account for the importance of social networks in the employment process. This view holds that personal connections are key for both workers and employees. Hence, employees are more likely to apply for jobs where they have a personal connection, and are more likely to be hired if they apply. In response to this issue, a large literature has recently evolved that attempts to identify statistical discrimination in hiring, looking at whether group membership, most notably race, influences firms' hiring decisions. More generally, sociologists and political economists claim that labor economics tends to lose sight of the complexity of individual employment decisions. These decisions, particularly on the supply side, are often loaded with considerable emotional baggage and a purely numerical analysis can miss important dimensions of the process.

Also missing from most labor market analyses is the role of unpaid labor. Even though this type of labor is unpaid it can nevertheless play an important part in society. The most dramatic example is child raising. However, over the past 25 years an increasing literature, usually designated as the economics of the family, has sought to study within household decision making, including joint labor supply, fertility, child raising, as well as other areas of what is generally referred to as home production.

8. References
Orley C. Ashenfelter and Richard Layard, ed., 1986, Handbook of Labor Economics. Amsterdam: North-Holland. Richard Blundell and Thomas MaCurdy, 2008. "labour supply," The New Palgrave Dictionary of Economics, 2nd Edition Abstract. R.B. Freeman, 1987. "Labour economics," The New Palgrave Dictionary of Economics, v. 3, pp. 7276. John R. Hicks, 1932, 2nd ed., 1963. The Theory of Wages. London, Macmillan. Mark R. Killingsworth, 1983. Labour Supply. Cambridge: Cambridge Surveys of Economic Literature. Jacob Mincer, 1974. Schooling, Experience, and Earnings. New York: Columbia University Press. Anindya Bakrie and Morendy Octora, 2002. Schooling, Experience, and Earnings. New York, Singapore National University: Columbia University Press. Simon Head, The New Ruthless Economy. Work and Power in the Digital Age, Oxford UP 2005, ISBN 0-19-517983-8 L. Ali Khan, The Dignity of Labour David Romer, 2006, Advanced Microeconomics, Third Edition, McGraw-Hill Irwin Michael Parkin, 1995, Microeconomics, Third Edition, Addison-Wesley Publishing Company.