Questions: (1) Where do the labor

demand and supply curves come from?

(2) How well do they explain the facts?
12_01
WAGE
(PRICE OF
LABOR)
QUANTITY OF LABOR
Labor
demand
Market
wage
Amount of labor where
quantity of labor supplied
equals quantity of labor
demanded
Labor
supply
The Slowdown in Wage Growth
12_02
INDEX,
1992 = 100
110
100
90
80
70
60
1960 1965 1970 1975 1980 1985 1990 1995 2000
Real wage
High growth
trend
Low growth
trend

Two sides of the labor market:
Firms and Workers
Labor Demand
The firms decision
Labor Supply
The workers decision
Derived Demand for Labor
Labor demand is a derived from firms
profit maximization decisions
Firm chooses output to maximize profits
(MC = P)
This amount of output implies a level of
labor input (short run)
a production function all over again
Market power? Not yet, lets first
start with competition
A firm in a competitive market for its good:
takes price as given
But now also assume that the labor market
is competitive: firm takes wage as given
Example: Competitive Firm with
P = $100 (T12.1)
Workers Quantity
produced
Marginal
Product
Total
Revenue
Marginal
Revenue
Product
0 0 -- 0 --
1 17 17 1700 1700
2 31 14 3100 1400
3 42 11 4200 1100
4 51 9 5100 900
5 58 7 5800 700
To derive the labor demand
curve, first plot MRP by hand
Marginal Revenue Product
Equals Wage
Condition for Profit Maximization
In symbols: MRP = W
For firms in competitive markets:
MRP = PxMP
example 1700 = 100x17 or 1400 = 100x14
This implies that MP = W/P
Marginal product of labor equals real wage

To get market demand for labor,
sum up firms demands for labor
12_04
WEEKLY WAGE
(DOLLARS)
WEEKLY WAGE
(DOLLARS)
WEEKLY WAGE
(DOLLARS)
1,500 1,500 1,500
1,000 1,000 1,000
500 500 500
5 0 0 0 10 5 10 5 10 15 20
QUANTITY OF LABOR
(NUMBER OF WORKERS)
QUANTITY OF LABOR
(NUMBER OF WORKERS)
QUANTITY OF LABOR
(NUMBER OF WORKERS)
LABOR DEMAND IN THE MARKET LABOR DEMAND AT CAREERPRO LABOR DEMAND AT GETAJOB

What if firm has market power
as in a monopoly?
Still must have MRP = W
But in this case MRP does not equal P=MP
because P is not fixed
P must decrease as L and Q go up
Derivation of Labor Supply
analogy with earlier analysis of consumer
behavior: purposeful choices (work versus
leisure) with limited resources (only 24
hrs in a day)
The price of leisure is the opportunity
cost of not working = wage
As the wage rises, the price of leisure rises
thus the person will work more
Leisure includes school!
Investing in human capital
more human capital increase marginal
product of a worker
Substitution versus income
effect in labor supply
Recall the two effects for a good
the two effects go in the same direction
in case of labor supply the two effects go in
opposite directions
hence labor supply can slope down!!!!!!!

3 different labor supply curves
12_05
WAGE WAGE WAGE
Labor
supply
Labor
supply
Labor
supply
QUANTITY OF LABOR QUANTITY OF LABOR QUANTITY OF LABOR
INCOME EFFECT DOMINATES SUBSTITUTION EFFECT EQUALS
INCOME EFFECT
SUBSTITUTION EFFECT DOMINATES
Backward bending labor supply
curve
12_06
WAGE
LABOR SUPPLY
Substitution effect
dominates in this
region.
Income and
substitution effects
balance out.
Income effect
dominates in
this region.
A Test: compare trend in labor
productivity with trend in real
wage
12_07
INDEX,
1992 = 100
110
100
90
80
Labor productivity
70
60
50
1960 1965 1970 1975 1980 1985 1990 1995 2000
High growth
trend
Low growth
trend
But productivity theory does not
explain everything
Compensating wage differentials
salaries in the business school versus the
economics department
Efficiency Wages
Long Term Employment Contracts
wage is related to productivity over long
periods, but not short periods
Effects of Minimum Wage
12_09
Quantity of
labor demanded
Quantity of
labor supplied
Minimum
wage
Labor market
equilibrium
Labor
demand
Labor
demand
Labor
supply
Labor
supply
WAGE WAGE
QUANTITY OF LABOR QUANTITY OF LABOR
Surplus
Market for Unskilled Workers Market for Skilled Workers
Discrimination in competitive
markets
12_08
WAGE
Labor supply
Actual marginal
revenue product
NUMBER OF WOMEN WORKERS
4. Because actual marginal
revenue product is higher
than the wage, other firms
can hire these women at a
higher wage but still below
the marginal revenue
product.
1. Prejudiced firm acts
as if marginal revenue
product is lower than
it actually is.
2. Discrimination
causes wages
to fall by this
amount.
3. Discrimination also
causes lower
employment for women.
Effects of Labor Unions