Chapter 15

 The labor supply is the willingness

and ability to work specific amounts
of time at alternative wage rates in a
given time period, ceteris paribus.
 The opportunity cost of working is
the amount of leisure time that must
be given up in the process.
 Higher wage rates are needed to
compensate for the increasing
opportunity cost of labor.
 The marginal utility of income may
decline as you earn more.
 Theupward slope of an individual’s
labor-supply curve is a reflection of
two phenomena:
– The increasing opportunity cost of labor as
leisure time declines.
– The decreasing marginal utility of income as a
person works more hours.
 Labor supply
Wage Rate (dollars per hour)

B
w2

A
w1

People supply more

Labor when wages rise

0 q1 q2
Quantity of Labor (hours per week)
 Higher wages represent more goods
and services and thus induce people
to substitute labor for leisure.
 Substitution Effect of Wages – An
increased wage rate encourages
people to work more hours (to
substitute labor for leisure).
A worker might also respond to
higher wage rates by working less,
not more.
• Income Effect of Wages – An increased
wage rate allows a person to reduce hours
worked without losing income.
 Ifincome effects outweigh
substitution effects, an individual will
supply less labor at higher wages.
Wage Rate (dollars per hour)

Income effects
dominate

Substitution
effects
dominate

0
Quantity of Labor Supplied (hours per week)
 The market supply of labor is the
total quantity of labor that workers
are willing and able to supply at
alternative wage rates in a given
time period, ceteris paribus.
 Thelabor supply curve shifts when
the determinates of labor supply
change:
– Tastes – for leisure, income, and work.
– Income and wealth.
– Expectations – for income or consumption.
– Prices of consumer goods.
– Taxes.
 Overtime, the labor supply curve
has shifted leftward:
 A rise in living standards.
 Income transfer programs that provide
economic security when not working.
 Increased diversity and attractiveness of
leisure activities.
 We use the concept of elasticity to
measure the movements along the
labor-supply curve resulting from
wage rate changes.
 Theelasticity of labor supply is
the percentage change in the
quantity of labor supplied divided by
the percentage change in wage rate.
A workers responsiveness to wage
changes is often constrained by
institutional constraints such as
specified work hours such as 8 – 5
shifts.
 The demand for labor is the
quantity of labor employers are
willing and able to hire at alternative
wage rates in a given time period,
ceteris paribus.
 The quantity of resources purchased
by a business depends on the firm’s
expected sales and output.
 It is a derived demand.
 Derived demand is the demand for
labor and other factors of production
resulting from (depending on) the
demand for final goods and services
produced by these factors.
 The number of workers hired is not
completely dependent upon the
demand for the product.
 The quantity of labor demanded also
depends on its price (the wage rate).
 Demand for labor
Wage Rate (dollars per hour)

More workers are

A sought at lower wages
W1

B
W2

0 L1 L2
Quantity of Labor (hours per month)
 Marginal physical product (MPP)
is the change in total output
associated with one additional unit of
input.
 Marginal revenue product (MRP)
- the change in total revenue
associated with one additional unit of
input.

MRP = MPP X p
 Marginalrevenue product sets an
upper limit to the wage rate an
employer will pay.
 The marginal physical product of
labor eventually declines as the
quantity of labor employed
increases.
 According to the law of
diminishing returns, the marginal
physical product of a variable factor
declines as more of it is employed
with a given quantity of other (fixed)
inputs.
Units of Labor Total Output Marginal Physical Product
0 0 —
1 5 5
2 10 5
3 14 4
4 17 3
5 19 2
6 20 1
7 20 0
8 18 -2
9 15 -3
 22 G
F
20 E
18 H
D
Output of Strawberries

16 I
Total output
(boxes per hour)

14 C
12
10 B
8
6 b
A c
4 d
e
2 f g
0 h
–2 Marginal output i
(per picker)
–4
0 1 2 3 4 5 6 7 8 9 10
Number of Pickers (per hour)
 Asmarginal physical product
diminishes, so does marginal
revenue product.
 Marginal
revenue product
determines how much labor will be
hired.
A firm that is a perfect competitor in
the labor market can hire all the
labor it wants at the prevailing
market wage.
 An employer will continue to hire
people until the MRP has declined to
the level of the market wage rate.
 Each (identical) worker is worth no
more than the marginal revenue
product of the last worker hired, and
all workers are paid the same wage
rate.
 $11
MARGINAL REVENUE PRODUCT

A B
10
9
8
(dollars per hour)

7 MRP
6
5
C
4 Wage rate
3 D
2
1

0 1 2 3 4 5 6 7 8 9
QUANTITY OF LABOR (workers per hour)
 There is a tradeoff between wages
and the number of workers hired.
 If the wage rates go up, fewer
workers will be hired.
 $12
A B Lower wages spur
Wage Rate (dollars per hour)

10 more hires
8
MRP = demand
6 G

C Initial wage rate

4

D New wage rate

2

0 1 2 3 4 5 6 7 8 9
Quantity of Labor Demanded (pickers per hour)
 To get higher wages without
sacrificing jobs, productivity (MRP)
must increase.
 Increased productivity implies that
workers can get higher wages
without sacrificing jobs or more
employment without lowering
wages.
 $12
D2 Higher productivity spurs
Wage Rate (dollars per hour)

10 more hires
D1
8 New demand curve

6 F

E Initial wage rate

4
C
2
Initial demand curve

0 1 2 3 4 5 6 7 8 9
Quantity of Labor Demanded (pickers per hour)
 An increase in product price will also
increase MRP and thus demand for
labor.
 Price changes depend on changes in
the market supply and demand for
the product being sold.
 The
market demand for labor
depends on:
 The number of employers.
 The marginal revenue product of labor in
each firm and industry.
 The market supply of labor depends
on:
– The number of workers.
– Each worker’s willingness to work at
alternative wage rates.
 The intersection of the market
supply and demand establishes the
equilibrium wage.
 The equilibrium wage is the wage
at which the quantity of labor
supplied in a given time period
equals the quantity of labor
demanded.
 Competitive employers act like price
takers with respect to wages as well
as prices.
 The labor market A competitive firm
Wage Rate (dollars per hour)

Market
supply
Labor supply
confronting firm
we we

Market
demand
MRP of
firm's labor
q0
Quantity of Labor Quantity of Labor
(workers per time period) (workers per time period)
Agovernment-imposed minimum
wage (wage floor):
 Reduces the quantity of labor
demanded.
 Increases the quantity of labor supplied.
 Creates a market surplus.
 Thesize of the job loss caused by a
higher minimum wage depends on
labor-market conditions.
 When the minimum wage is below
the equilibrium wage, an increase in
the minimum may have little or no
adverse employment effects.
 Thefurther the minimum wage rises
above the market’s equilibrium
wage, the greater the job loss.
 Labor demand Labor supply
Wage Rate (dollars per hour)

Market surplus
wm
Minimum wage
E
we
Workers who keep Equilibrium wage rate
jobs at higher wage

Job New entrants who

losers can't find jobs
0 qd qe qs
Quantity of Labor (hours per year)
 Employers can use more machinery
in place of labor.
 To determine whether to hire a
worker or use a machine, a firm
compares the ratio of the marginal
physical products to their cost.
 This ratio expresses the cost
efficiency of an input.
 Cost efficiency is the amount of
output associated with an additional
dollar spent on input – the MPP of a
product divided by its price (cost).
 Themost cost-efficient factor is the
one that produces the most output
per dollar.
 Typically
a producer does not choose
between individual inputs but rather
between alternative production
processes.
 Production process - A specific
combination of resources used to
produce a good or service.
 A lte rn a tiv e P ro ce sse s fo r P ro d u cin g
O n e T o n o f S tra w b e rrie s

In p u t P ro ce ss A P ro ce ss B P ro ce ss C
L a b o r (h o u rs) 400 270 220
M a ch in e ry (h o u rs) 13 15 18
L a n d (a cre s) 1 1 1
 The producer seeks to use the
combination of resources that
produces a given rate of output for
the least cost.
 Efficiency decision - The choice of a
production process for any given rate of
output.
 Critics of CEO pay believe that CEO
paychecks are out of line with
realities of supply and demand.
 They want corporations to revise the
process used for setting CEO pay
levels.
 One of the difficulties in determining
the appropriate level of CEO pay is
the elusiveness of marginal revenue
product.
 The wage of CEOs is set by their
opportunity wage.
 The opportunity wage is the
highest wage an individual would
earn in his or her best alternative
job.
 Ifmarkets work efficiently, such
government intervention should not
be necessary.
 Corporations that pay their CEOs
excessively will end up with smaller
profits than companies who pay
market-based wages.
End of Chapter 15