Labour economics

Labor economics seeks to understand the functioning of the labor market. 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.

There are two sides to labor economics. Labour economics can be seen as the application of microeconomic techniques to the labor market or the use of macroeconomic techniques. Microeconomic techniques study the role of individuals in the labor market. Macroeconomic techniques look at the interlations between the labour market, the goods market, the money market, and the foriegn trade market. It looks at how these interactions influence macro variables such as employment levels, participation rates, aggregate income and Gross Domestic Product

The microeconomics of labor markets

Economists see the labour market as similar to any other market 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 prices. 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. A rise in overall wages will not generally 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, or it may result in no change in supply if workers on average decide to save their increased pay. It is difficult to see how it would increase the supply. Within the overall labor market, particular labor markets are thought to be subject to more normal rules of supply and demand as workers are attracted to change job types in response to differing wages.

Many economists have thought that, in the absence of laws or organisations such as unions, labor markets can be close to perfectly competitive in the economic sense - that is, there are many workers and employers both having perfect information about each other and there are no transaction costs. The competitive assumption leads to clear conclusions - workers earn their marginal product of labor.

Other economists focus on deviations from perfectly competitive labor markets. These include job search, training and gaining-of-experience costs to switch between job types, efficiency wage models and oligopsony / monopsonistic competition.

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 constrainted by the waking hours available to them.

Let w denote hourly wage.
Let k denote total waking hours. 
Let L denote working hours. 
Let π 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 + π, A)
s.t.   L + A <= k

This can be shown in a diagram (below) that illustrates the trade-off between allocating your time between leisure activities and income generating activities. The linear constraint line indicates that there are only 24 hours in a day, and individuals must choose how much of this time to allocate to leisure activities and how much to working. (If multiple days are being concidered the maximum number of hours that could be allocated towards leisure or work is about 16 - We have to sleep eventually!) This allocation decision is informed by the curved indifference curve labeled IC. The curve indicates the combinations of leisure and work that will give the individual a specific level of utility. The point where the highest indifference curve is just tangent to the constraint line (point A), illustrates the short-run equilibrium for this supplier of labour services.

The Income/Leisure trade-off in the short run

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 constrait 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). Because the marginal rate of substitution, leisure for income, is also the ratio of the marginal utility of leisure (MU^L) to the marginal utility of income (MU^Y), we can conclude:

{{MU^{L}} \over {MU^{Y}}}={{dY} \over {dL}}

Effects of a wage increase

If wages increase, this individual's constraint line pivots up from X,Y₁ to X,Y₂. He/she can now purchase more goods and services. His/her utility will increase from point A on IC₁ to point B on IC₂. To understand what effect this might have on the decision of how many hours to work, we must look at the income effect and substitution effect.

The wage increase shown in the previous diagram can be decompiled into two separate effects. The pure income effect is shown as the movement from point A to point C in the next diagram. Consumption increases from Y_A to Y_C and leisure time increases from X_A to X_C (employment time decreases by the same amount; X_A to X_C).

The Income and Substitution effects of a wage increase

But that is only part of the picture. As the wage rate rises, the worker will substitute work hours for leisure hours, that is, will work more hours to take advantage of the higher wage rate. This substitution effect is represented by the shift from point C to point B. The net impact of these two effects is shown by the shift from point A to point B. The relative magnitude of the two effects depends on the circumstances. In some cases the substitution effect is greater than the income effect (in which case more time will be allocated to working), but in other cases the income effect will be greater than the substitution effect (in which case less time is allocated to employment activities). The intuition behind this latter case is that the worker has reach the point where his marginal utility of leisure outweights his marginal utility of income. To put it in less formal (and less accurate) terms, There is no point in earning more money if you don't have the time to spend it.

The Labour Supply curve

If the substitution effect is greater than the income effect, the supply of labour curve (diagram to the left) will slope upwards to the right, as it does at point E for example. This individual will continue to increase his supply of labour services as the wage rate increases up to point F where he is working H_F hours (each period of time). Beyond this point he will start to reduce the amount of labour hours he supplies (for example at point G he has reduced his work hours to H_G). Where the supply curve is sloping upwards to the right (positive wage elasticity of labour supply), the substitution effect is greater than the income effect. Where it slopes upwards to the left (negative elasticity), the income effect is greater than the substitution effect.

Other variables that affect this decision include taxation, welfare, and work environment.

Neoclassical microeconomic model - Demand

We have examined the labour 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, labour demand is a derived demand: it is derived from the output levels in the goods market.

A firm's labour demand is based on its marginal physical product of labour (MPP). This is defined as the additional output (or physical product) that results from an increase of one unit of labour (or from an infinitecimally small increase in labour). If you are not familiar with these concepts, you might want to look at production theory basics before continuing with this article.

The Marginal Physical Product of Labour

In most industries, and over the relevent range of outputs, the marginal physical product of labour is declining. That is, as more and more units of labour are employed, their additional output begins to decline. This is reflected by the slope of the MPP_L curve in the diagram to the right. If the marginal physical product of labour is multiplied by the value of the output that it produces, we obtain the Value of marginal physical product of labour:

MPP_L * P_Q = VMPP_L

The value of marginal physical product of labour (VMPP_L) is the value of the additional output produced by an additional unit of labour. This is illustrated in the diagram by the VMPP_L curve that is above the MPP_L by the price of the output that is produced.

In competitive industries, the VMPP_L is in identity with the marginal revenue product of labour (MRP_L). This is because in competitive markets price is equal to marginal revenue, and marginal revenue product is defined as the marginal physical product times the marginal revenue from the output (MRP = MPP * MR).

A Firm's Labour Demand in the Short Run

The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. In competitive markets, a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginal resource cost of labour (W = S_L = M = MFC_L). In imperfect markets, the diagram would have to be adjusted because MFC_L would then be equal to the wage rate divided by marginal costs. Because optimum resource allocation requires that marginal factors costs equal marginal revenue product, this firm would demand L units of labour in the diagram.

Neoclassical microeconomic model - Equilibrium

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

Labour economics

The microeconomics of labor markets

Neoclassical microeconomic model - Supply

Neoclassical microeconomic model - Demand

Neoclassical microeconomic model - Equilibrium

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