Introduction to Labor Economics

Why Study Labor Economics Human resources allocate substantial time and energy to labor markets. Labor economics studies how labor markets work. Labor economics helps us understand and address many social and economic problems facing modern societies. 2016 McGraw-Hill Education. All Rights Reserved. 3

Basics of the Labor Market Participants are assigned motives: Workers look for the best job. Firms look for profits. Government uses regulation to achieve goals of public policy. Minimum wages Occupational safety 2016 McGraw-Hill Education. All Rights Reserved. 4

Three Actors Workers The most important actor; without workers, there is no labor. Desire to maximize utility (i.e., to optimize by selecting the best option from available choices). Supplies more time and effort for higher payoffs, causing an upward sloping labor supply curve. 2016 McGraw-Hill Education. All Rights Reserved. 5

Three Actors Firms Decide who to hire and fire. Motivated to maximize profits. Relationship between price of labor and the number of workers a firm is willing to hire generates the labor demand curve. 2016 McGraw-Hill Education. All Rights Reserved. 6

Why Do We Need a Theory Explain and understand how labor markets work. Focus on the essential variables while leaving out other, less crucial, factors. Create a model that helps explain the theory. 2016 McGraw-Hill Education. All Rights Reserved. 8

Positive vs. Normative Economics Positive economics Addresses the facts Focus on what is Questions answered with the tools of economists Normative economics Addresses values Focus on what should be Requires judgments 2016 McGraw-Hill Education. All Rights Reserved. 9

Supply and Demand in the Engineering Labor Market Earnings ($) Labor Supply Curve 50,000 40,000 Equilibrium 30,000 Labor Demand Curve 10,000 20,000 30,000 Employment 2016 McGraw-Hill Education. All Rights Reserved. 10

Summary Labor economics studies how labor markets work. Models in labor economics typically contain three actors: workers, firms, and governments. A good theory should have realistic assumptions and can be tested with real-world data. The tools of economics are helpful in answering positive questions. 2016 McGraw-Hill Education. All Rights Reserved. 13

Where Are We Going? Worker supply decisions Firm demand decisions Labor market equilibrium Differences in job characteristics Differences in worker characteristics Labor mobility Labor marker discrimination Unionization Incentive pay schemes Unemployment 2016 McGraw-Hill Education. All Rights Reserved. 14

Multiple Regression Extending regression analysis to include multiple independent variables Each estimated coefficient shows the impact of a particular variable on the dependent variable, other things constant Standard errors of the regression coefficients are used to evaluate significance of the relations between each particular variable and the dependent variable 2016 McGraw-Hill Education. All Rights Reserved. 19

Labor Supply Chapter 2

Introduction to Labor Supply Labor facts Men: labor force participation rates declined from 80% in 1900 to 72% in 2009. Women: labor force participation rates rose from 21% in 1900 to 59% in 2009. Hours worked fell from 40 to 34 per week during the same time period. 2016 McGraw-Hill Education. All Rights Reserved. 3

Measuring the Labor Force Current population survey (CPS) Labor Force = Employed + Unemployed LF = E + U Size of LF does not tell us about intensity of work. Labor Force Participation Rate LFPR = LF/P P = civilian adult population 16 years or older not in institutions. 2016 McGraw-Hill Education. All Rights Reserved. 4

Measuring the Labor Force Current population survey (CPS) Employment: Population Ratio (percent of population that is employed). EPR = E/P Unemployment Rate UR = U/LF 2016 McGraw-Hill Education. All Rights Reserved. 5

Measuring the Labor Force Labor force measurement relies on subjectivity and likely understates the effects of a recession. Hidden unemployed: persons who have given up in their search for work and have therefore left the labor force. The employment rate (E/P) can be a better measure of fluctuations in economic activity than the unemployment rate. 2016 McGraw-Hill Education. All Rights Reserved. 6

Labor Force Participation Facts Labor force participation (LFP) is greatest for all groups during the ages of 25 to 55. LFP increases with education. LFP has decreased for men over the age of 65 from 63% in 1900 to under 22% by 2010. 2016 McGraw-Hill Education. All Rights Reserved. 7

Labor Force Participation Facts More women than men work part-time. More men who are high school drop outs work than women who are high school drop outs. White men have higher participation rates and hours of work than black men. 2016 McGraw-Hill Education. All Rights Reserved. 8

Utility Function Neo-Classical Model of Labor-Leisure Choice Measure of satisfaction individuals receive from consumption (C) of goods and leisure (L). U = f(c, L) U is an index. The higher is U, the happier is the person. 2016 McGraw-Hill Education. All Rights Reserved. 11

Indifference Curves Downward sloping, indicating the tradeoff between consumption and leisure. Higher curves = higher utility. Do not intersect. Convex to the origin, indicating that opportunity costs increase. 2016 McGraw-Hill Education. All Rights Reserved. 12

Differences in Preferences Consumption ($) Consumption ($) U 1 U 1 U U 0 0 Hours of Leisure Hours of Leisure Workers with steeper indifference curves value their leisure relatively more than workers with shallower indifference curves. 2016 McGraw-Hill Education. All Rights Reserved. 14

The Budget Constraint The budget constraint defines the worker s opportunity set, indicating all of the consumption leisure combinations the worker can afford. C = wh + V Consumption equals labor earning (wages hours of work) plus nonlabor income (V). As h = T L, can rewrite C = w(t L) + V. 2016 McGraw-Hill Education. All Rights Reserved. 15

The Hours of Work Decision Individuals choose consumption and leisure to maximize utility. Optimal consumption is given by the point where the budget line is tangent to the indifference curve. At this point the marginal rate of substitution (MRS) between consumption and leisure equals the wage. Any other consumption leisure bundle on the budget constraint would give the individual less utility. 2016 McGraw-Hill Education. All Rights Reserved. 17

The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F 1 F 0 P 1 U 1 $200 P 0 U 0 E 1 $100 E 0 70 80 110 Hours of Leisure An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P 0 to point P 1. If leisure is a normal good, hours of work fall. 2016 McGraw-Hill Education. All Rights Reserved. 19

The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F 1 F 0 P 1 U 1 $200 P 0 U 0 E 1 $100 E 0 60 70 110 An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P 0 to point P 1. If leisure is inferior, hours of work increase. 2016 McGraw-Hill Education. All Rights Reserved. 20

More Leisure at a Higher Wage When the income effect dominates the substitution effect, the worker increases hours of leisure in response to an increase in the wage. Consumption ($) G U 1 D R Q F U 0 P D V E 0 70 75 85 110 Hours of Leisure 2016 McGraw-Hill Education. All Rights Reserved. 21

More Work at a Higher Wage When the substitution effect dominates the income effect, the worker decreases hours of leisure in response to an increase in the wage. Consumption ($) G U 1 D U 0 R Q D F P V E 0 65 70 80 110 Hours of Leisure 2016 McGraw-Hill Education. All Rights Reserved. 22

To Work or Not to Work? Are the terms of trade sufficiently attractive to bribe a worker to enter the labor market? Reservation wage: the lowest wage rate that would make the person indifferent between working and not working. Rule 1: if the market wage is less than the reservation wage, then the person will not work. Rule 2: the reservation wage increases as nonlabor income increases 2016 McGraw-Hill Education. All Rights Reserved. 23

Labor Supply Curve Relationship between hours worked and the wage rate. At wages slightly above the reservation wage, the labor supply curve is positively sloped (the substitution effect dominates the income effect). If the income effect begins to dominate the substitution, hours of work decline as the wage rate increases (a negatively sloped labor supply curve). 2016 McGraw-Hill Education. All Rights Reserved. 25

Labor Supply Elasticity The labor supply elasticity (σ) measures responsiveness in hours worked to changes in the wage rate. σ = Percent change in hours worked divided by the percent change in wage rate. Labor supply elasticity less than 1 is inelastic as hours of work respond proportionally less than the change in wages. Labor supply elasticity greater than 1 is elastic as hours of work respond proportionally more than the change in wages. 2016 McGraw-Hill Education. All Rights Reserved. 27

Labor Supply of Women Substantial cross-country differences in women s labor force participation rates. Over time, women s participation rates have increased. In most studies on female labor supply, the substitution effect dominates the income effect for women, implying an upward sloped labor supply curve. 2016 McGraw-Hill Education. All Rights Reserved. 28

Growth in Female Labor Force Participation Rates and the Wage Cross Countries, 1960-1980 Source: Jacob Mincer, Intercountry Comparisons of Labor Force Trends and of Related Developments: An Overview, Journal of Labor Economics 3 (January 1985, Part 2): S2, S6. 2016 McGraw-Hill Education. All Rights Reserved. 29

Policy Application: Welfare Programs and Work Incentives Cash grants reduce wage incentives. Welfare programs create work disincentives. Welfare reduces supply of labor by increasing nonlabor income, which raises the reservation wage. 2016 McGraw-Hill Education. All Rights Reserved. 30

Effect of a Cash Grant on Work Incentives A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G, and encourages the worker to leave the labor force. Consumption ($) F 500 P G U 1 U 0 0 70 110 Hours of Leisure 2016 McGraw-Hill Education. All Rights Reserved. 31

Policy Application: The Earned-Income Tax Credit The EITC should increase labor force participation of nonworkers of targeted groups. The EITC encourages some non-workers to start working and never encourages a worker to quit working. The EITC produces an income effect. Hours worked should change. 2016 McGraw-Hill Education. All Rights Reserved. 33

The EITC and the Budget Line Consumption ($) 35,263 F G Net wage is 21.06% below the actual wage 18,770 H Net wage equals the actual wage 15,400 14,370 J Net wage is 40% above the actual wage 11,000 E 110 Hours of Leisure 2016 McGraw-Hill Education. All Rights Reserved. 34

Labor Supply over the Life Cycle Wage rates change over the worker s life (over the life cycle). Wages are low when young. Wages rise with time and peak around age 50. Wages decline or remain stable after age 50. The changes in wages over the life cycle are evolutionary wage changes that alter the price of leisure. 2016 McGraw-Hill Education. All Rights Reserved. 35

Theoretical Issues of Evolutionary Wages A person will work more hours when wages are higher (i.e., the substitution effect tends to dominate the income effect). The profile of hours of work over the life cycle will have the same shape as the ageearnings profile. Intertemporal substitution hypothesis: people substitute their time over the life cycle to take advantages of changes in the price of leisure. 2016 McGraw-Hill Education. All Rights Reserved. 36

Hours of Work over the Life Cycle for Two Workers with Different Wage Paths Wage Rate Hours of Work Joe Joe (if substitution effect dominates) Jack Jack t * Age t * Joe (if income effect dominates) Joe s wage exceeds Jack s at every age. Although both Joe and Jack work more hours when the wage is high, Joe works more hours than Jack if the substitution effect dominates. If the income effect dominates, Joe works fewer hours than Jack. Age 2016 McGraw-Hill Education. All Rights Reserved. 38

Labor force participation rate Labor Force Participation Rates over the Life Cycle in 2013 100 90 80 Male 70 60 Female 50 40 30 15 25 35 45 55 65 Age 2016 McGraw-Hill Education. All Rights Reserved. 39

Labor Supply Over the Added-worker effect. Business Cycle So-called secondary workers currently out of the labor market are affected by a recession because the main breadwinner becomes unemployed or faces a wage cut. A secondary worker may choose to enter the labor force during these bad times The labor force participation rate of secondary workers (i.e., the added worker effect) is countercyclical. 2016 McGraw-Hill Education. All Rights Reserved. 41

Labor Supply Over the Business Cycle Discouraged worker effect. Unemployed workers find it very difficult to find jobs during a recession, so they give up searching. Discouraged workers exit the labor force during bad times. The labor force participation rate of discouraged workers is pro-cyclical. 2016 McGraw-Hill Education. All Rights Reserved. 42

Labor Supply Over the Business Cycle The discouraged worker effect dominates the added-worker effect, especially during recessions. The Labor Force Participation Rate is procyclical 2016 McGraw-Hill Education. All Rights Reserved. 43

Retirement Lifetime income is higher the longer a worker puts off retirement. If pension benefits are constant, wage increases have a substitution and income effect, so lifetime income might not be altered. An increase in pension benefits reduces the price of retirement, increasing the demand for leisure and encouraging the worker to retire earlier. 2016 McGraw-Hill Education. All Rights Reserved. 44

The Impact of the Social Security Earnings Test on Hours of Work The Social Security earnings test (which taxed retirees when they earned more than $17,000 per year) generated the budget line that affects behavior in varying ways. The repeal of the earnings test moved retirees to another budget line, as a result: One retiree would not change his hours of work. A second retiree would reduce his hours. A third retiree might increase or decrease his hours, depending on whether substitution or income effects dominate. 2016 McGraw-Hill Education. All Rights Reserved. 45

The Impact of the Social Security Earnings Test on Hours of Work Conclusions: (1) Overall, the theory suggests that elimination of the Social Security earnings test is unlikely to substantially increase labor supply among retirees. (2) The empirical evidence confirms the theoretical explanations: the labor supply effects of the repeal tended to be small. 2016 McGraw-Hill Education. All Rights Reserved. 46

Introduction Firms hire workers because consumers want to purchase a variety of goods and services. Demand for workers is derived from the wants and desires of consumers. Central questions: how many workers are hired and what are they paid? 2016 McGraw-Hill Education. All Rights Reserved. 3

The Firm s Production Function Describes the technology that the firm uses to produce goods and services. The firm s output can be produced by a variety of capital labor combinations. The marginal product of labor is the change in output resulting from hiring an additional worker, holding constant the quantities of other inputs. The marginal product of capital is the change in output resulting from employing one additional unit of capital, holding constant the quantities of other inputs. 2016 McGraw-Hill Education. All Rights Reserved. 4

The Total Product, the Marginal Product, and the Average Product Curves The total product curve gives the relationship between output and the number of workers hired by the firm (holding capital fixed). The marginal product curve shows the output produced by each additional worker, and the average product curve shows output per worker. 2016 McGraw-Hill Education. All Rights Reserved. 5

Profit Maximization Objective of the firm is to maximize profits. The profit function is: Profits = pq we rk Total Revenue = pq Total Costs = (we + rk) Perfectly competitive firms cannot influence prices of output or inputs. 2016 McGraw-Hill Education. All Rights Reserved. 6

Short Run Hiring Decision Value of Marginal Product of Employment (VMP E ) is the marginal product of labor times the dollar value of the output. VMP E indicates the dollar benefit derived from hiring an additional worker, holding capital constant. Value of Average Product of Employment is the dollar value of output per worker. 2016 McGraw-Hill Education. All Rights Reserved. 7

The Firm s Hiring Decision in the Short-Run A profitmaximizing firm hires workers up to the point where the wage rate equals the value of marginal product of labor. If the wage is $22, the firm hires eight workers. 2016 McGraw-Hill Education. All Rights Reserved. 8

Labor Demand Curve The demand curve for labor indicates how many workers the firm hires for each possible wage, holding capital constant. The labor demand curve is downward sloping. This reflects the fact that additional workers are costly and alter average production due to the Law of Diminishing Returns. 2016 McGraw-Hill Education. All Rights Reserved. 9

The Short-Run Demand Curve for Labor Because marginal product eventually declines, the short-run demand curve for labor is downward sloping. A drop in the wage from $22 to $18 increases the firm s employment. An increase in the price of the output shifts the value of marginal product curve upward (to the right), and increases employment. 2016 McGraw-Hill Education. All Rights Reserved. 10

Maximizing Profits: Two Rules The profit maximizing firm should produce up to the point where the cost of producing an additional unit of output (marginal cost) is equal to the revenue obtained from selling that output (marginal revenue). Marginal Productivity Condition: hire labor up to the point where the value of marginal product equals the added cost of hiring the worker (i.e., the wage). 2016 McGraw-Hill Education. All Rights Reserved. 11

The Mathematics of Marginal Productivity Theory The cost of producing an extra unit of output: MC = w x (1 / MP E ) The condition: produce to the point where MC = P (for the competitive firm, P = MR) W x (1 / MP E ) = P 2016 McGraw-Hill Education. All Rights Reserved. 12

Critiques of Marginal Productivity Theory A common criticism is that the theory bears little relation to the way that employers make hiring decisions. Another criticism is that the assumptions of the theory are not very realistic. However, employers act as if they know the implications of marginal productivity theory (hence, they try to make profits and remain in business). 2016 McGraw-Hill Education. All Rights Reserved. 13

The Firm s Output Decision Dollars p MC Output Price A profit-maximizing firm produces up to the point where the output price equals the marginal cost of production. q * Output 2016 McGraw-Hill Education. All Rights Reserved. 15

The Employment Decision in the Long Run In the long run, the firm maximizes profits by choosing how many workers to hire AND how much plant and equipment to invest in. Isoquant curves describe the possible combinations of labor and capital that produce the same level of output 2016 McGraw-Hill Education. All Rights Reserved. 16

Isoquant Curves K Capital X Y q 0 q 1 All capital-labor combinations that lie on a single isoquant produce the same level of output. The input combinations at points X and Y produce q 0 units of output. Combinations of input bundles that lie on higher isoquants must produce more output. E Employment 2016 McGraw-Hill Education. All Rights Reserved. 17

Isocost Lines The isocost line indicates all labor capital bundles that exhaust a specified budget for the firm. Isocost lines indicate equally costly combinations of inputs. Higher isocost lines indicate higher costs. 2016 McGraw-Hill Education. All Rights Reserved. 18

Isocost Lines C 1 /r C 0 /r Capital Isocost with Cost Outlay C 1 Isocost with Cost Outlay C 0 All capital-labor combinations that lie on a single isocost curve are equally costly. Capitallabor combinations that lie on a higher isocost curve are more costly. The slope of an isoquant equals the ratio of input prices (-w/r). C 0 /w C 1 /w 2016 McGraw-Hill Education. All Rights Reserved. 19

The Firm s Optimal Combination of C 1 /r C 0 /r Capital 175 A P B Inputs q 0 A firm minimizes the cost of producing q 0 units of output by using the capital-labor combination at point P, where the isoquant is tangent to the isocost. All other capital-labor combinations (such as those given by points A and B) lie on a higher isocost curve. 100 Employment 2016 McGraw-Hill Education. All Rights Reserved. 20

Cost Minimization Profit maximization implies cost minimization. The firm chooses the least-cost combination of capital and labor. This least-cost choice is where the isocost line is tangent to the isoquant. Marginal rate of substitution equals the ratio of input prices, w / r, at the least-cost choice. 2016 McGraw-Hill Education. All Rights Reserved. 21

Long Run Demand for Labor When the wage drops, two effects arise. The firm takes advantage of the lower price of labor by expanding production (the scale effect). The firm takes advantage of the wage change by rearranging its mix of inputs, by employing more labor and less of other inputs, even if holding output constant (the substitution effect) 2016 McGraw-Hill Education. All Rights Reserved. 22

C 0 /r The Impact of a Wage Reduction Capital 75 P Holding Costs Constant R q 0 A wage reduction flattens the isocost curve. If the firm were to hold the initial cost outlay constant at C 0 dollars, the isocost would rotate around C 0 and the firm would move from point P to point R. A profitmaximizing firm, however, will not generally want to hold the cost outlay constant when the wage changes. Wage is w 0 Wage is w 1 25 40 2016 McGraw-Hill Education. All Rights Reserved. 23

The Impact of a Wage Reduction on the Output and Employment of a Profit- Maximizing Firm Dollars Capital MC 0 MC 1 p P R 150 100 150 Output 25 50 Employment A wage cut reduces the marginal cost of production and encourages the firm to expand (from producing 100 to 150 units). The firm moves from point P to point R, increasing the number of workers hired from 25 to 50. 2016 McGraw-Hill Education. All Rights Reserved. 24 100

Substitution and Scale Effects C 1 /r C 0 /r Capital D P Q R D 100 Wage is w 0 200 Wage is w 1 A wage cut generates substitution and scale effects. The scale effect (from P to Q) encourages the firm to expand, increasing the firm s employment. The substitution effect (from Q to R) encourages the firm to use a more laborintensive method of production, further increasing employment. 25 40 50 Employment 2016 McGraw-Hill Education. All Rights Reserved. 25

Two Special Cases of Isoquants Capital Capital 100 q 0 Isoquant 5 q 0 Isoquant 200 Employment 20 Employment Capital and labor are perfect substitutes if the isoquant is linear (so that two workers can always be substituted for one machine). The two inputs are perfect complements if the isoquant is right-angled. The firm then gets the same output when it hires 5 machines and 20 workers as when it hires 5 machines and 25 workers. 2016 McGraw-Hill Education. All Rights Reserved. 26

Elasticity of Substitution The elasticity of substitution is the percentage change in the capital to labor ratio given a percentage change in the price ratio (wages to real interest). Formula: % (K/L) % (w/r). Interpret a particular elasticity of substitution number as the percentage change in the capital labor ratio given a 1% change in the relative price of labor to capital 2016 McGraw-Hill Education. All Rights Reserved. 27

Elasticity of Substitution Example: If the elasticity of substitution is 5, then a 10% increase in the ratio of wages to the price of capital would result in the firm increasing its capitalto-labor ratio by 50%. 2016 McGraw-Hill Education. All Rights Reserved. 28

Long Run Demand Curve for Labor Dollars w 0 w 1 The long-run demand curve for labor gives the firm s employment at a given wage and is downward sloping. D LR 25 50 Employment 2016 McGraw-Hill Education. All Rights Reserved. 29

The Short- and Long-Term Demand Curves for Labor Dollars Short-Run Demand Curve Long-Run Demand Curve In the long run, the firm can take full advantage of the economic opportunities introduced by a change in the wage. As a result, the long-run demand curve is more elastic than the shortrun demand curve. Employment 2016 McGraw-Hill Education. All Rights Reserved. 30

Application Affirmative action and production costs: A firm is color blind if race does not enter the hiring decision. Discrimination shifts the hiring decision away from the cost minimization tangency point on the isoquant. 2016 McGraw-Hill Education. All Rights Reserved. 31

Affirmative Action Black Labor Q P The discriminatory firm chooses the input mix at point P, ignoring the cost-minimizing rule that the isoquant be tangent to the isocost. An affirmative action program can force the firm to move to point Q, resulting in more efficient production and lower costs. q * White Labor 2016 McGraw-Hill Education. All Rights Reserved. 32

Affirmative Action Black Labor Q A color-blind firm is at point P, hiring relatively more whites because of the shape of the isoquants. An affirmative action program will increase this firm s costs if it must further increase its amount of black labor. P q * White Labor 2016 McGraw-Hill Education. All Rights Reserved. 33

Marshall s Rules Labor Demand is more elastic when: The elasticity of substitution is greater. The elasticity of demand for the firm s output is greater. Labor s share in total costs of production is greater. The elasticity of supply of other factors of production such as capital is greater. 2016 McGraw-Hill Education. All Rights Reserved. 34

Factor Demands When There Are Several Inputs There are many different inputs. Skilled and unskilled labor Old and young Old and new machines Cross-elasticity of factor demand. Percent change in x i Percent change in w j If cross-elasticity is positive, the two inputs are said to be substitutes in production. 2016 McGraw-Hill Education. All Rights Reserved. 35

The Demand Curve for a Factor of Production Affected by the Prices of Other Inputs Price of input i Price of input i D 0 D 1 D 0 D 1 Employment of input i Employment of input i The labor demand curve for input i shifts when the price of another input changes. (a) If the price of a substitutable input rises, the demand curve for input i shifts up. (b) If the price of a complement rises, the demand curve for input i shifts down. 2016 McGraw-Hill Education. All Rights Reserved. 36

Labor Market Equilibrium w high w * w low Dollars Supply Demand In a competitive labor market, equilibrium is attained at the point where supply equals demand. The marketclearing wage is w* at which E* workers are employed. E D E * E S Employment 2016 McGraw-Hill Education. All Rights Reserved. 37

Application: The Employment Effects of Minimum Wages The unemployment rate is higher the higher the minimum wage and the more elastic are the labor supply and demand curves. The benefits of the minimum wage accrue mostly to workers who are not at the bottom of the distribution of permanent income. 2016 McGraw-Hill Education. All Rights Reserved. 38

The Impact of the Minimum Wage Dollars on Employment w * w D S A minimum wage set at w results in employers cutting employment from E* to E. The higher wage also encourages E S E* workers to enter the market. Thus, under a minimum wage, E S E workers are unemployed. E E * E S Employment 2016 McGraw-Hill Education. All Rights Reserved. 39

Minimum Wages in the United States, 1938-2011 8 0.6 7 6 0.5 5 Ratio 4 0.4 3 2 0.3 1 Nominal Minimum Wage 0 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 0.2 Year 2016 McGraw-Hill Education. All Rights Reserved. 40

The Impact of Minimum Wages on the Covered and Uncovered Sectors Dollars S C Dollars S U (If workers migrate to covered sector) w S U w * w * S U (If workers migrate to uncovered sector) D C D U E E C Employment E U E U E U (b) Uncovered Sector Employment If the minimum wage applies only to jobs in the covered sector, the displaced workers might move to the uncovered sector, shifting the supply curve to the right and reducing the uncovered sector s wage. If it is easy to get a minimum wage job, workers in the uncovered sector might quit their jobs and wait in the covered sector until a job opens up, shifting the supply curve in the uncovered sector to the left and raising the uncovered sector s wage. 2016 McGraw-Hill Education. All Rights Reserved. 41

Asymmetric Variable Adjustment Costs Variable Adjustment Costs C 0-25 0 +50 Change in Employment Changing employment quickly is costly, and these costs increase at an increasing rate. If government policies prevent firms from firing workers, the costs of trimming the workforce will rise even faster than the costs of expanding the firm. 2016 McGraw-Hill Education. All Rights Reserved. 42

Slow Transition to a New Labor Equilibrium Employment 150 100 A 50 B C Variable adjustment costs encourage the firm to adjust the employment level slowly. The expansion from 100 to 150 workers might occur more rapidly than the contraction from 100 to 50 workers if government policies tax firms that cut employment. Time 2016 McGraw-Hill Education. All Rights Reserved. 43

Estimating Labor Demand One can identify the slope of the labor demand curve, which can be used to calculate the elasticity of labor demand, when the supply curve shifts. Problem: Must make sure the labor demand curve is not also changing. 2016 McGraw-Hill Education. All Rights Reserved. 44

Introduction Labor market equilibrium coordinates the desires of firms and workers, determining the wage and employment observed in the labor market. Market types: Monopsony: one buyer of labor Monopoly: one seller of labor These market structures generate unique labor market equilibria. 2016 McGraw-Hill Education. All Rights Reserved. 3

Equilibrium in a Single Competitive Labor Market Competitive equilibrium occurs when supply equals demand, generating a competitive wage and employment level. It is unlikely that the labor market is ever in an equilibrium, since supply and demand are dynamic. The model suggests that the market is always moving toward equilibrium. 2016 McGraw-Hill Education. All Rights Reserved. 4

Efficiency Pareto efficiency exists when all possible gains from trade have been exhausted. When the state of the world is (Pareto) Efficient, to improve one person s welfare necessarily requires decreasing another person s welfare. In policy applications, ask whether a change can make any one better off without harming anyone else. If the answer is yes, then the proposed change is said to be Paretoimproving. 2016 McGraw-Hill Education. All Rights Reserved. 5

Equilibrium in a Competitive Labor Market w * Dollars P Q S D 0 The labor market is in equilibrium when supply equals demand; E* workers are employed at a wage of w*. In equilibrium, all persons who are looking for work at the going wage can find a job. The triangle P gives the producer surplus; the triangle Q gives the worker surplus. A competitive market maximizes the value of output, or the sum P + Q. E L E * E H Employment 2016 McGraw-Hill Education. All Rights Reserved. 6

Competitive Equilibrium Across Labor Markets If workers were mobile and entry and exit of workers to the labor market was free, then there would be a single wage paid to all workers. The allocation of workers to firms equating the wage to the value of marginal product is also the allocation that maximizes national income (this is known as allocative efficiency). The invisible hand process: self-interested workers and firms accomplish a social goal that no one had in mind, i.e., allocative efficiency. 2016 McGraw-Hill Education. All Rights Reserved. 7

Efficiency Revisited The single wage property of a competitive equilibrium has important implications for economic efficiency. Recall that in a competitive equilibrium the wage equals the value of marginal product of labor. As firms and workers move to the region that provides the best opportunities, they eliminate regional wage differentials. Therefore, workers of given skills have the same value of marginal product of labor in all markets. The allocation of workers to firms that equates the value of marginal product across markets is also the sorting that leads to an efficient allocation of labor resources. 2016 McGraw-Hill Education. All Rights Reserved. 8

Wages and International Trade: NAFTA NAFTA created a free trade zone in North America. Free trade reduces the income differential between the United States and other countries in the zone, such as Mexico. Total income of the countries in the trade zone is maximized as a result of equalized economic opportunities across the countries in the zone. 2016 McGraw-Hill Education. All Rights Reserved. 9

Competitive Equilibrium in Two Labor Markets Linked by Migration Dollars Dollars S N s S S S S w N A w * B w * C w S (a) The Northern Labor Market D N Employment (b) The Southern Labor Market D S Employment Suppose the wage in the northern region (w N ) exceeds the wage in the southern region (w S ). Southern workers want to move North, shifting the southern supply curve to the left and the northern supply curve to the right. In the end, wages are equated across regions at w*. 2016 McGraw-Hill Education. All Rights Reserved. 10

Wage Convergence Across States 5.7 LA Percent Annual Wage Growth 5.5 5.3 5.1 4.9 4.7 MS AR GA FL NC SC MENH VT VA TN AL ND NE RI SD KS MD MA IA CT DE OK MO PA MN TX WI NM UT AZ NJ NY KY WV IN IL CO MT MI WA CA NV ID OR OH 4.5.9 1.1 1.3 1.5 1.7 1.9 Manufacturing Wage in 1950 WY Source: Olivier Jean Blanchard and Lawrence F. Katz, Regional Evolutions, Brookings Papers on Economic Activity 1 (1992): 1-61. 2016 McGraw-Hill Education. All Rights Reserved. 11

Payroll Taxes and Subsidies Payroll taxes assessed on employers lead to a downward, parallel shift in the labor demand curve. The new demand curve shows a wedge between the amount the firm must pay to hire a worker and the amount that workers actually receive. Payroll taxes increase total costs of employment, so these taxes reduce employment in the economy. Firms and workers share the cost of payroll taxes, since the cost of hiring a worker rises and the wage received by workers declines. Payroll taxes result in deadweight losses. 2016 McGraw-Hill Education. All Rights Reserved. 12

The Impact on Payroll Tax Assessed on Firms w 1 + 1 w 0 1 Dollars w 0 w 1 B E 1 E 0 A D 1 S D 0 A payroll tax of $1 assessed on employers shifts down the demand curve (from D 0 to D 1 ). The payroll tax decreases the wage that workers receive from w 0 to w 1, and increases the cost of hiring a worker from w 0 to w 1 + 1. 2016 McGraw-Hill Education. All Rights Reserved. 13

The Impact on Payroll Tax Assessed on Workers Dollars w 0 + 1 w 1 w 0 w 1 1 D 1 S 1 S 0 D 0 A payroll tax assessed on workers shifts the supply curve to the left (from S 0 to S 1 ). The payroll tax has the same impact on the equilibrium wage and employment regardless of who it is assessed on. E 1 E 0 2016 McGraw-Hill Education. All Rights Reserved. 14

The Impact on Payroll Tax Put on Firms Dollars w 0 w 0 1 with Inelastic Supply E 0 S D 0 A B D 1 D 0 Employment A payroll tax assessed on the firm is shifted completely to workers when the labor supply curve is perfectly inelastic. The wage is initially w 0. The $1 payroll tax shifts the demand curve to D 1, and the wage falls to w 0 1. 2016 McGraw-Hill Education. All Rights Reserved. 15

Payroll Subsidies An employment subsidy lowers the cost of hiring for firms. This means payroll subsidies shift the demand curve for labor to the right (up). Total employment will increase as the cost of hiring has fallen. 2016 McGraw-Hill Education. All Rights Reserved. 16

The Impact of an Employment Subsidy w 0 + 1 w 1 w 0 w 1 1 A B D 0 S D 1 An employment subsidy of $1 per worker hired shifts up the labor demand curve, increasing employment. The wage that workers receive rises from w 0 to w 1. The wage that firms actually pay falls from w 0 to w 1 1. E 0 E 1 Employment 2016 McGraw-Hill Education. All Rights Reserved. 17

The Impact of a Mandated Benefit Dollars S 0 Dollars S 0 w * w * + C S P 1 w 0 + B P S 1 w 0 w 1 Q w * R w 0 C w * R D 0 D 0 D 1 D 1 E 1 E * E 0 Employment E 0 Employment (a) Cost of mandate exceeds worker s valuation (b) Cost of mandate equals worker s valuation 2016 McGraw-Hill Education. All Rights Reserved. 18

Immigration As immigrants enter the labor market, the labor supply curve shifts to the right. Total employment increases. Equilibrium wage decreases. 2016 McGraw-Hill Education. All Rights Reserved. 19

Effect on Native-Born Workers Immigration reduces the wages and employment of similarly-skilled native-born workers, but native-born workers may be able to increase their productivity by specializing in tasks better suited to their skills. Competing native workers will have lower wages; complementary native workers will have higher wages. 2016 McGraw-Hill Education. All Rights Reserved. 20

The Short-Run Impact of Immigration When Immigrants and Natives Are Perfect Substitutes Dollars w 0 w 1 N 1 N 0 E 1 Supply Demand Employment As immigrants and natives are perfect substitutes, the two groups are competing in the same labor market. Immigration shifts out the labor supply curve. As a result, the wage falls from w 0 to w 1, and total employment increases from N 0 to E 1. At the lower wage, the number of natives who work declines from N 0 to N 1. 2016 McGraw-Hill Education. All Rights Reserved. 21

The Short-Run Impact of Immigration when Immigrants and Natives are Complements Dollars w 1 w 0 N 0 N 1 Supply Demand Employment If immigrants and natives are complements, they do not compete in the same labor market. The labor market here denotes the supply and demand for native workers. Immigration makes natives more productive, shifting out the labor demand curve. This leads to a higher native wage and to an increase in native employment. 2016 McGraw-Hill Education. All Rights Reserved. 22

The Long-Run Impact of Immigration When Immigrants and Natives Are Perfect Substitutes Dollars w 0 w 1 N 0 N 0 + Immigrants Supply Demand Employment Immigration initially shifts out the labor supply curve so the wage falls from w 0 to w 1. Over time, capital expands as firms take advantage of the cheaper workforce, shifting out the labor demand curve and restoring the original wage and level of native employment. 2016 McGraw-Hill Education. All Rights Reserved. 23

The Short-Run Labor Demand Curve Implied by Different Natural Experiments Dollars Demand curve implied by Mariel natural experiment Dollars D Demand curve implied by minimum wage natural experiment w * D (a) Mariel Employment E* (b) NJ-Pennsylvania minimum wage Employment (a) The analysis of data resulting from the Mariel natural experiment implies that increased immigration does not affect the wage, so that the short-run labor demand curve is perfectly elastic. (b) The analysis of data resulting from the NJ-Pennsylvania minimum wage natural experiment implies that an increase in the minimum wage does not affect employment, so that the short-run labor demand curve is perfectly inelastic. 2016 McGraw-Hill Education. All Rights Reserved. 24

The Native Labor Market s Response to Immigration Dollars Dollars S 0 S 2 S 1 S 0 S 3 P LA P PT w 0 w 0 w * w * w LA Demand Employment Demand Employment (a) Los Angeles (b) Pittsburgh Originally, both markets pay equilibrium wages of w 0. After immigration into Los Angeles, both markets eventually converge to a new equilibrium wage at w*, which is less than w 0. 2016 McGraw-Hill Education. All Rights Reserved. 25

Policy Application: Environmental Disasters and the Labor Market Hurricanes generate exogenous economic shocks that affect labor market conditions. Can use data to estimate difference-indifference models that examine the economic impact on affected Florida counties relative to unaffected counties. Next slide data: 19 hurricanes that hit Florida between 1988 and 2005. 2016 McGraw-Hill Education. All Rights Reserved. 28

Changes in Employment and Wages in Florida Counties Hit by Hurricanes 1. Effect of category 1-3 hurricane on county directly hit 2. Effect of category 4-5 hurricane on county directly hit 3. Effect of category 1-3 hurricane on neighboring county 4. Effect of Category 4-5 hurricane in neighboring county Percent change in employment Percent change in earnings -1.5 +1.3-4.5 +4.4 +0.2-4.5 +0.8-3.3 Source: Ariel R. Belasen and Solomon W. Polachek, How Disasters Affect Local Labor Markets: The Effects of Hurricanes in Florida, Journal of Human Resources, forthcoming 2009, Table 4. 2016 McGraw-Hill Education. All Rights Reserved. 29

Policy Application: Environmental Disasters and the Labor Market How does the theory of labor market equilibrium gain support from this data? Labor supply decreases in counties directly hit, and more so in the more-affected counties. This increases wages and lowers employment. Labor supply increases in neighboring counties. This decreases wages and increases employment. 2016 McGraw-Hill Education. All Rights Reserved. 30

The Cobweb Model Two assumptions of the cobweb model: Time is needed to produce skilled workers. Persons decide to become skilled workers by looking at conditions in the labor market at the time they enter school. A cobweb pattern forms around the equilibrium. The cobweb pattern arises when people are misinformed. The model assumes naïve workers who do not form rational expectations. Rational expectations are formed if workers correctly perceive the future and understand the economic forces at work. 2016 McGraw-Hill Education. All Rights Reserved. 31

The Cobweb Model in the Market for Dollars w 1 w 3 w * w 2 w 0 New Engineers S D D The initial equilibrium wage in the engineering market is w 0. The demand for engineers shifts to D, and the wage will eventually increase to w*. Because new engineers are not produced instantaneously and because students might misjudge future opportunities in the market, a cobweb is created as the market adjusts to the increase in demand. E 0 E E * 2 E 1 Employment 2016 McGraw-Hill Education. All Rights Reserved. 32

Noncompetitive Labor Markets: Monopsony Monopsony market exists when a firm is the only buyer of labor. Monopsonists must increase wages to attract more workers. Two types of monopsonist firms: Perfectly discriminating Nondiscriminating 2016 McGraw-Hill Education. All Rights Reserved. 33

Perfectly Discriminating Monopsonist Discriminating monopsonists are able to hire different workers at different wages. To maximize firm surplus (profits), a perfectly discriminating monopsonist perfectly discriminates by paying each worker his or her reservation wage. 2016 McGraw-Hill Education. All Rights Reserved. 34

Nondiscriminating Monopsonist Must pay all workers the same wage, regardless of each worker s reservation wage. Must raise the wage of all workers when attempting to attract more workers. Employs fewer workers than would be employed if the market were competitive. 2016 McGraw-Hill Education. All Rights Reserved. 35

The Hiring Decision of a Perfectly Discriminating Monopsonist Dollars w * w 30 w 10 10 30 E * S A VMP E Employment A perfectly discriminating monopsonist faces an upwardsloping labor supply curve and can hire different workers at different wages. Therefore the labor supply curve gives the marginal cost of hiring. Profit maximization occurs at point A. The monopsonist hires the same number of workers as a competitive market, but each worker is paid his or her reservation wage. 2016 McGraw-Hill Education. All Rights Reserved. 36

The Hiring Decision of a Nondiscriminating Monopsonist Dollars VMP M w * w M A MC E S A nondiscriminating monopsonist pays the same wage to all workers. The marginal cost of hiring exceeds the wage, and the marginal cost curve lies above the supply curve. Profit maximization occurs at point A; the monopsonist hires E M workers and pays them all a wage of w M. E M E * VMP E Employment 2016 McGraw-Hill Education. All Rights Reserved. 37

The Impact of the Minimum Wage on a Nondiscriminating Monopsonist Dollars w * w M w A MC E S The minimum wage may increase both wages and employment when imposed on a nondiscriminating monopsonist. A minimum wage set at w increases employment to E. VMP E E M E Employment 2016 McGraw-Hill Education. All Rights Reserved. 38

Introduction The labor market is not characterized by a single wage: workers differ and jobs differ. Adam Smith proposed the idea that job characteristics influence labor market equilibrium. Compensating wage differentials arise to compensate workers for nonwage characteristics of the job. Workers have different preferences and firms offer different working conditions. 2016 McGraw-Hill Education. All Rights Reserved. 3

The Market for Risky Jobs Workers care about whether their job is safe or risky. Utility = f(wage, risk of injury). Indifference curves reveal the worker s preferences between wages and risk. Firms may have a risky work environment because it is less expensive to pay higher wages than to make the environment safe. 2016 McGraw-Hill Education. All Rights Reserved. 4

Indifference Curves Relating the Wage and the Probability of Injury Dw Wage ŵ 1 w 1 w 0 P Q U 1 U 0 U 1 The worker earns a wage of w 0 and gets U 0 utils if she chooses the safe job. She would prefer the safe job if the risky job paid a wage of w 1, but would prefer the risky job if that job paid a wage of w 1. The worker is indifferent between the two jobs if the risky job pays w^1. The worker s reservation price is then given by Δw = w^1 - w 0. 0 1 Probability of Injury 2016 McGraw-Hill Education. All Rights Reserved. 5

Determining the Market Compensating Differential (w 1 -w 0 ) * w 1 - w 0 ^ Dw^ MIN E * P S D Number of Workers in Risky Job The supply of labor to risky jobs slopes up because as the wage gap between the risky job and the safe job increases, more and more workers are willing to work in the risky job. The demand curve slopes down because fewer firms will offer risky working conditions if risky firms have to offer high wages to attract workers. The market compensation differential equates supply and demand, and gives the bribe required to attract the last worker hired by risky firms. 2016 McGraw-Hill Education. All Rights Reserved. 6

Market Equilibrium When Some Workers Prefer Risky Jobs w 1 - w 0 0 (w 1 -w 0 ) * Dw^ MIN D E * P N S Number of Workers in Risky Job If some workers like to work in risky jobs (i.e., they are willing to pay for the right to be injured) and if the demand for such workers is small, then the market compensating differential is negative. At point P, where supply equals demand, workers employed in risky jobs earn less than workers employed in safe jobs. 2016 McGraw-Hill Education. All Rights Reserved. 7

Hedonic Wage Theory Workers maximize utility by choosing wage-risk combinations that offer them the greatest amount of utility. Isoprofit curves are upward sloping because production of safety is costly. Isoprofit curves are concave because production of safety is subject to the law of diminishing returns. Hedonic wage functions reflect the relationship between wages and job characteristics. 2016 McGraw-Hill Education. All Rights Reserved. 8

Indifference Curves for Three Types of Workers Wage U A U B U C Different workers have different preferences for risk. Worker A is very riskaverse. Worker C does not mind risk very much at all. Worker B is between the two. Probability of Injury 2016 McGraw-Hill Education. All Rights Reserved. 9

Isoprofit Curves Wage R Q P p 0 p 1 An isoprofit curve gives all the riskwage combinations that yield the same profits. Because it is costly to produce safety, a firm offering risk level ρ* can make the workplace safer only if it reduces wages (while keeping profits constant), so that the isoprofit curve is upward sloping. Note: higher isoprofit curves yield lower profits. r * Probability of Injury 2016 McGraw-Hill Education. All Rights Reserved. 10

The Hedonic Wage Function Wage P A p X U A p Y P B U B p Z P C U C Hedonic Wage Function Different firms have different isoprofit curves and different workers have different indifference curves. The labor market marries workers who dislike risk (such as worker A) with firms that find it easy to provide a safe environment (like firm X); and workers who do not mind risk very much (worker C) with firms that find it difficult to provide a safe environment (firm Z). The observed relationship between wages and job characteristics is called a hedonic wage function. Probability of Injury 2016 McGraw-Hill Education. All Rights Reserved. 11

Policy Application: How Much is a Life Worth? Studies report a positive relationship between wages and work hazards. The statistical value of life is the amount that workers are jointly willing to pay to reduce the likelihood that one of them will suffer a fatal injury in a given year on the job. The empirical evidence is ambiguous on the estimates of the value of a life. 2016 McGraw-Hill Education. All Rights Reserved. 12

Policy Application: How Much is a Life Worth? Calculating the Value of Life (VoL) w x = annual earnings in Firm X w y = annual earnings in Firm Y The probabilities of fatal injury in Firm X and Firm Y are given as ρ x and ρ y. If X is a safe job and Y is the risky job, then: VoL = (w y w x ) / (ρ y ρ x ) 2016 McGraw-Hill Education. All Rights Reserved. 13

Policy Application: Safety and Health Regulation OSHA is charged with the protection and health of the American labor force. OSHA sets regulations that are aimed at reducing risks in the work environment. Mandated standards reduce the utility of workers and the profits of firms. Safety regulations can improve workers welfare as long as workers consistently underestimate the true risks. 2016 McGraw-Hill Education. All Rights Reserved. 14

Impact of OSHA Regulation on Wage, Profits, and Utility Wage w * w Q r * P r * U * U p p * Hedonic Wage Function Probability of Injury A worker maximizes utility by choosing the job at point P, which pays a wage of w* and offers a probability of injury of ρ*. The government prohibits firms from offering a probability of injury higher than r, shifting both the worker and the firm to point Q. As a result, the worker earns a lower wage and receives less utility (from U* to U ), and the firm earns lower profits (from p* to p ). 2016 McGraw-Hill Education. All Rights Reserved. 15

Impact of OSHA Regulations When Workers Misperceive Risks Wage w * r 0 r U 0 U U * r * Hedonic Wage Function Probability of Injury Workers earn a wage of w* and incorrectly believe that their probability of injury is only ρ 0. In fact, their probability of injury is ρ*. The government can mandate that firms do not offer a probability of injury higher than r, making the uninformed workers better off (that is, increasing their actual utility from U* to U ). 2016 McGraw-Hill Education. All Rights Reserved. 16

Compensating Differentials and Job Amenities Good job characteristics are associated with low wage rates. Bad job characteristics are associated with high wage rates. The evidence is not clear on the link between amenities and wage differentials, except for the risk of death. Examples of amenities: job security, predictability of layoffs, work schedules, work hours, safety, etc. 2016 McGraw-Hill Education. All Rights Reserved. 17

Layoffs and Compensating Differentials Income Wage = w 0 L 0 h 0 P Wage = w 1 Q L 1 h 1 R T 0 U U 0 Hours of Leisure Hours of Work At point P, a person maximizes utility by working h 0 hours at a wage of w 0 dollars. An alternative job offers the worker a seasonal schedule, where she receives the same wage but works only h 1 hours. The worker is worse off in the seasonal job (her utility declines from U 0 to U utils). If the seasonal job is to attract any workers, the job must raise the wage to (w 1 ) so that workers will be indifferent between the two jobs. 2016 McGraw-Hill Education. All Rights Reserved. 18

Health Benefits and Compensating Differentials Wage w A w B P Q Q * U A U B U B* Isoprofit p * Workers A and B face the various compensation packages offered by isoprofit curve p 0. Worker A chooses a package with a high wage and no health insurance benefits. Worker B chooses a package with wage w B and health benefits H B. The observed data identifies the tradeoff between job benefits and wages. In contrast, workers B and B* have different earnings potential, so their job packages lie on different isoprofit curves. Their choices generate a positive correlation between wages and health benefits. The observed data do not identify the trade-off between wages and health benefits. Isoprofit p 0 H B Health benefits ($) 2016 McGraw-Hill Education. All Rights Reserved. 19

Introduction People bring into the labor market a unique set of abilities and acquired skills known as human capital. Workers add to their stock of human capital throughout their lives, especially via job experience and education. 2016 McGraw-Hill Education. All Rights Reserved. 3

Present Value Calculations Present value allows comparison of dollar amounts spent and received in different time periods. (An idea from finance.) Present Value = PV = y/(1+r) t r is the per-period discount rate. y is the future value. t is the number of time periods. 2016 McGraw-Hill Education. All Rights Reserved. 5

Potential Earnings Streams Faced by a Dollars High School Graduate w COL w HS 0 -H 18 22 65 Goes to College Quits After High School Age A person who quits school after getting her high school diploma can earn w HS from age 18 until retirement. If she decides to go to college, she foregoes these earnings and incurs a cost of H dollars for 4 years and then earns w COL until retirement. 2016 McGraw-Hill Education. All Rights Reserved. 6

The Schooling Model Real earnings (earnings adjusted for inflation). Age-earnings profile: the wage profile over a worker s lifespan. The higher the discount rate, the less likely someone will invest in education (since they are less future oriented). The discount rate depends on: the market rate of interest. time preferences: how a person feels about giving up today s consumption in return for future rewards. 2016 McGraw-Hill Education. All Rights Reserved. 7

The Wage-Schooling Locus The salaries firms are willing to pay workers depend on the level of schooling. Properties of the wage-schooling locus. The wage-schooling locus is upward sloping. The slope of the wage-schooling locus indicates the increase in earnings associated with an additional year of education. The wage-schooling locus is concave, reflecting diminishing returns to schooling. 2016 McGraw-Hill Education. All Rights Reserved. 8

The Wage-Schooling Locus The wage-schooling locus gives the salary that a particular worker would earn if he completed a particular level of schooling. If the worker graduates from high school, he earns $20,000 annually. If he goes to college for 1 year, he earns $23,000. And so on. Dollars 30,000 25,000 23,000 20,000 0 12 13 14 18 Years of Schooling 2016 McGraw-Hill Education. All Rights Reserved. 9

Education and the Wage Gap Observed data on earnings and schooling does not allow us to estimate returns to schooling, because more able persons tend to get more education. Ability bias: The extent to which unobserved ability differences exist affects estimates on returns to schooling, since the ability difference may be the true source of the wage differential. 2016 McGraw-Hill Education. All Rights Reserved. 10

The Schooling Decision Rate of Discount r r s s* MRR Years of Schooling The MRR schedule gives the marginal rate of return to schooling, or the percentage increase in earnings resulting from an additional year of school. A worker maximizes the present value of lifetime earnings by going to school until the marginal rate of return to schooling equals the rate of discount. A worker with discount rate r goes to school for s* years. 2016 McGraw-Hill Education. All Rights Reserved. 11

Schooling and Earnings When Workers Have Different Rates of Discount Rate of Interest Dollars w HS P BO r AL w DROP P AL r BO MRR 11 12 Years of 11 Schooling 12 Years of Schooling 2016 McGraw-Hill Education. All Rights Reserved. 12

Schooling and Earnings When Workers Have Different Abilities Rate of Interest w HS Dollars Z Bob w ACE Ace r w DROP P ACE MRR BOB MRR ACE 11 12 Years of Schooling 11 12 Years of Schooling Ace and Bob have the same discount rate (r) but each worker faces a different wage-schooling locus. Ace drops out of high school and Bob gets a high school diploma. The wage differential between Bob and Ace (w HS - w DROP ) arises both because Bob goes to school for one more year and because Bob is more able. As a result, this wage differential does not tells us by how much Ace s earnings would increase if he were to complete high school (w ACE - w DROP ). 2016 McGraw-Hill Education. All Rights Reserved. 13

Estimating the Rate of Return to Schooling A typical empirical study estimates a regression of the form: Log(w) = a s + other variables w is the wage rate s is the years of schooling a is the coefficient that estimates the rate of return to an additional year of schooling 2016 McGraw-Hill Education. All Rights Reserved. 14

Evidence In studies of twins, presumably holding ability constant, valid estimates of rate of return to schooling can be estimated. Estimates range from 3% to 15% annual return to a year of education. Generally, the rate of return to schooling is higher for workers who were born in states with well-funded education systems. 2016 McGraw-Hill Education. All Rights Reserved. 15

School Quality and the Rate of Return to Schooling Rate of return to schooling 8 7 6 5 4 3 2 15 20 25 30 35 40 Rate of return to schooling 8 7 6 5 4 3 2 0.5 0.75 1 1.25 1.5 1.75 2 Pupil/teacher ratio Relative teacher wage Source: David Card and Alan B. Krueger, Does School Quality Matter? Returns to Education and the Characteristics of Public Schools in the United States, Journal of Political Economy 100 (February 1992), Tables 1 and 2. The data in the graphs refer to the rate of return to school and the school quality variables for the cohort of persons born in 1920-1929. 2016 McGraw-Hill Education. All Rights Reserved. 16

Do Workers Maximize Lifetime Earnings? The schooling model assumes that workers select their level of education to maximize the present value of lifetime earnings. To test this hypothesis directly, we must observe the age-earnings profile at two points in time. Unfortunately, once a choice is made, we cannot observe the earnings associated with the non-choice. Thus, using the observed wage differential to determine if the worker selected the right earnings stream yields meaningless results. 2016 McGraw-Hill Education. All Rights Reserved. 17

Schooling as a Signal Education reveals a level of attainment which signals a worker s qualifications or innate ability to potential employers. Information that is used to allocate workers in the labor market is called a signal. There could be a separating equilibrium. Low-productivity workers choose not to obtain X years of education, voluntarily signaling their low productivity. High-productivity workers choose to get at least X years of schooling and separate themselves from the pack. 2016 McGraw-Hill Education. All Rights Reserved. 18

Education as a Signal Dollars Dollars Costs 300,000 300,000 Costs 250,001 y 200,000 Slope = 25,000 200,000 20,000 y Slope = 20,000 0 y Years of Schooling (a) Low-Productivity Workers 0 y Years of Schooling (b) High-Productivity Workers Workers get paid $200,000 if they get less than y years of college, and $300,000 if they get at least y years. Low-productivity workers find it expensive to invest in college, and will not get y years. High-productivity workers do obtain y years. As a result, the worker s education signals if he is a low-productivity or a high-productivity worker. 2016 McGraw-Hill Education. All Rights Reserved. 19

Implications of Schooling as a Signal For schooling to act as a signal, schooling must be more costly for low-ability workers compared to high-ability workers. Social return to schooling (percentage increase in national income) is likely to be positive even if a particular worker s human capital is not increased. Although education may incorporate a signaling aspect, it is well-accepted that education is more than a signal. Education is at least partially an investment in human capital. 2016 McGraw-Hill Education. All Rights Reserved. 20

Post-School Human Capital Investments Three important properties of age-earnings profiles: Highly educated workers earn more than less educated workers. Earnings rise over time at a decreasing rate. The age-earnings profiles of different education cohorts diverge over time (they fan outward ). Earnings increase faster for more educated workers. 2016 McGraw-Hill Education. All Rights Reserved. 21

Weekly Earnings Age-Earnings Profiles Men 2600 2300 2000 College Graduates 1700 1400 1100 800 500 Some college High school graduates High school dropouts 200 18 25 32 39 46 53 60 Age 2016 McGraw-Hill Education. All Rights Reserved. 22

Weekly Earnings Age-Earnings Profiles Women 1500 1300 1100 900 700 500 300 College Graduates Some college High school graduates High school dropouts 100 18 25 32 39 46 53 60 Age 2016 McGraw-Hill Education. All Rights Reserved. 23

On-The-Job Training Most workers augment their human capital stock through on-the-job training (OJT) after completing education investments. Two types of OJT: General: training that is useful at all firms once it is acquired. Specific: training that is useful only at the firm where it is acquired. 2016 McGraw-Hill Education. All Rights Reserved. 24

Implications Firms only provide general training if they do not pay the costs. In order for the firm to willingly pay some of the costs of specific training, the firm must share in the returns to specific training. Engaging in specific training eliminates the possibility of the worker separating from the job in the post-training period. 2016 McGraw-Hill Education. All Rights Reserved. 25

The Acquisition of Human Capital Over Dollars the Life Cycle MC MR 20 MR 30 0 Q 30 Q 20 Efficiency Units The marginal revenue of an efficiency unit of human capital declines as the worker ages (so that MR 20, the marginal revenue of a unit acquired at age 20, lies above MR 30 ). At each age, the worker equates the marginal revenue with the marginal cost, so that more units are acquired when the worker is younger. 2016 McGraw-Hill Education. All Rights Reserved. 26

Age-Earnings Profiles and OJT Human capital investments are more profitable the earlier they are taken. The Mincer earnings function: Log(w) = a s + b t c t 2 + other variables. The overtaking age is t* and indicates the time when the worker slows down acquisition of human capital to collect the return on prior investments so as to overtake earnings of those that did not undertake similar investments. 2016 McGraw-Hill Education. All Rights Reserved. 27

Dollars The Age-Earnings Profile Implied by Human Capital Theory Age-Earnings Profile Age The age-earnings profile is upward-sloping and concave. Older workers earn more because they invest less in human capital and because they are collecting the returns from earlier investments. The rate of growth of earnings slows down over time because workers accumulate less human capital as they get older. 2016 McGraw-Hill Education. All Rights Reserved. 28

Policy Application: Evaluating Government Training Programs Aimed at exposing disadvantaged and lowincome workers to training programs. $4 billion of federal spending per year. Studies of the return to these human capital investments are unclear, largely because of self-selection bias. 2016 McGraw-Hill Education. All Rights Reserved. 29

Social Experiments National Supported Worker Demonstration (NSW). Results of the NSW suggest a 10% return to investments in human capital for workers treated under the program. 2016 McGraw-Hill Education. All Rights Reserved. 30

Introduction Some workers will earn more than others. Productivity differences. Rate of return to skills differs. This chapter considers the factors that contribute to the shape of the wage distribution. 2016 McGraw-Hill Education. All Rights Reserved. 3

The Earnings Distribution The wage distribution is positively skewed. A long right tail. A small percent of workers earn disproportionately large shares of the rewards for work. 2016 McGraw-Hill Education. All Rights Reserved. 4

Facts About the Earnings Distribution Wage differentials exist due to: Human capital investments that vary from worker to worker. Age differences. (Young workers are still accumulating human capital, while older workers are collecting returns from earlier investments.) There is a positive correlation between ability and human capital investments, which stretches out wages in the population. 2016 McGraw-Hill Education. All Rights Reserved. 6

Measuring Inequality: The Lorenz Curve and the Gini Coefficient The perfect-equality Lorenz curve is given by the line AB, indicating that each quintile of households gets 20 percent of aggregate income. The actual Lorenz curve describes the actual income distribution. The ratio of the shaded area to the area in the triangle ABC gives the Gini coefficient. 2016 McGraw-Hill Education. All Rights Reserved. 8

Measuring Inequality: The Gini coefficient: The Gini Coefficient Increases as inequality increases. Summarizes the entire income distribution with a single number between 0 (perfect equality) and 1 (perfect inequality). 2016 McGraw-Hill Education. All Rights Reserved. 9

Measuring Inequality: Basic Facts Wage gaps provide wage ratios between different percentiles in the distribution. Examples of Wage Gap definitions: The 90-10 Wage Gap is the difference in the 90 th and 10 th percentiles as a percent of the 10 th percentile wage, or (w 90 w 10 )/w 10 The 50-10 Wage Gap is the difference in the 50 th and 10 th percentiles as a percent of the 10 th percentile wage, or (w 50 w 10 )/w 10 2016 McGraw-Hill Education. All Rights Reserved. 10

Changes in the Wage Structure: The 1980s The wage gap between those at the top of the wage distribution and those at the bottom widened dramatically. Wage differentials widened among education groups, experience groups, and age groups. Wage differentials widened within demographic and skill groups. 2016 McGraw-Hill Education. All Rights Reserved. 11

Gini coefficient Earnings Inequality for Full-Time, Year-Round Workers, 1937-2005: The Gini Coefficient 0.5 0.48 0.46 0.44 0.42 All workers 0.4 0.38 Women 0.36 0.34 0.32 Men 0.3 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year 2016 McGraw-Hill Education. All Rights Reserved. 12

Percentage wage gap Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 80-50 Wage Gap 0.65 0.6 0.55 0.5 Women 0.45 0.4 0.35 Men 0.3 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year 2016 McGraw-Hill Education. All Rights Reserved. 13

Percentage wage gap Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 50-20 Wage Gap 1.1 1 0.9 0.8 Women 0.7 0.6 0.5 Men 0.4 0.3 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year 2016 McGraw-Hill Education. All Rights Reserved. 14

Why Did Wage Inequality Increase? No single factor explains the changes. The increase in inequality seems to be caused by concurrent changes in economic fundamentals and labor market institutions. 2016 McGraw-Hill Education. All Rights Reserved. 16

Possible Factors That Widened the Wage Gap Demand for skilled workers increased relatively more than demand increased for unskilled workers. Increased physical capital helped to increase the productivity of skilled workers. A decrease in the supply of skilled workers or an increase in the demand for skilled workers could cause a widening of the wage gap. 2016 McGraw-Hill Education. All Rights Reserved. 17

Changes in the Wage Structure from Shifts in Supply and Demand Relative Wage of Skilled Workers r 1 r 0 S 0 A S 1 B p 0 p 1 C D 0 D 1 Relative Employment of Skilled Workers The downward-sloping demand curve implies that employers wish to hire relatively fewer skilled workers when the relative wage of skilled workers is high. The perfectly inelastic supply curve, S 0, indicates that the relative number of skilled workers is fixed. Initially, the labor market is in equilibrium at point A. Suppose the relative supply of skilled workers increases to S 1. The rising relative wage of skilled workers can then be explained only if there was a sizable outward shift in relative demand from D 0 to D 1 (ending at point C). 2016 McGraw-Hill Education. All Rights Reserved. 18

Why Did Wage Inequality Increase? Supply shifts. International trade. Skill-based technological change. Institutional changes in the U.S. labor market. Unions Minimum Wage 2016 McGraw-Hill Education. All Rights Reserved. 19

The Earnings of Superstars Superstar phenomenon a few persons in some professions earn very high salaries and seem to dominate their field. This suggests that even if a job is the same, different people bring different skills to the same job. 2016 McGraw-Hill Education. All Rights Reserved. 20

Superstar Earnings in the Entertainment Industry, 2010 Rank Name 2010 Income 1 Oprah Winfrey 315 2 James Cameron 210 3 U2 130 4 Tyler Perry 125 5 Michael Bay 120 6 AC/DC 114 7 Tiger Woods 105 8 Steven Spielberg 100 8 Jerry Bruckheimer 100 10 George Lucas 95 11 Beyonce Knowles 87 12 Simon Cowell 80 12 Dr. Phil McGraw 80 14 Jonny Depp 75 14 Jerry Seinfeld 75 2016 McGraw-Hill Education. All Rights Reserved. 21

Inequality Across Generations There is a positive correlation between the skills of parents and their children. High-income parents typically invest more in the education of their children than do lowincome parents. There is a tendency for income differences across families to get smaller over time ( regression toward the mean ). 2016 McGraw-Hill Education. All Rights Reserved. 22

The Intergenerational Link in Skills The slope of the regression line between child earnings and parental earnings is the intergenerational correlation. If the slope equals 1, the parent s earnings persists entirely into the next generation, and there is no regression toward the mean. If the slope equals 0, the wage of children is independent of the wage of the parents, and there is complete regression toward the mean. Earnings of Children 45 A, Slope = 1 C, Slope is between 0 and 1 B, Slope = 0 Earnings of Parents 2016 McGraw-Hill Education. All Rights Reserved. 23

Social Capital The quality of the environment where a child grows up helps determine human capital. There is evidence that varied factors influence a child s level of human capital. Quality of neighborhood. Importance of religious organizations. Socioeconomic background of classmates. 2016 McGraw-Hill Education. All Rights Reserved. 24

Geographic Labor Migration as an Investment in Human Capital Mobility decisions are guided by comparing present value of lifetime earnings among alternative employment opportunities in different locations. 2016 McGraw-Hill Education. All Rights Reserved. 4

Geographic Labor Migration as an Investment in Human Capital Improvements in economic opportunities available in a destination location increases the net gains to migration and raises the likelihood a worker moves. Improvements in economic opportunities available in the current location decreases the net gains to migration and lowers the likelihood a worker moves. An increase in migration costs lowers the net gains to migration, decreasing the probability a worker moves. 2016 McGraw-Hill Education. All Rights Reserved. 5

Geographic Labor Migration as an Investment in Human Capital A worker decides to move if the net gain from moving is positive. Migration occurs when there is a good chance the worker will recoup his investment in the move. 2016 McGraw-Hill Education. All Rights Reserved. 6

Internal Migration in the U.S. The probability of migration is sensitive to the income differential between the destination and original locations. There is a positive correlation between improved employment conditions and the probability of migration. There is a negative correlation between the probability of migration and distance. Distance is taken as a proxy for migration costs. 2016 McGraw-Hill Education. All Rights Reserved. 7

Internal Migration in the U.S. There is a positive correlation between a worker s educational attainment and the probability of migration. Workers that have migrated are likely to return to the location of origin (return migration) and are more likely to migrate again (repeat migration). 2016 McGraw-Hill Education. All Rights Reserved. 8

Family Migration The family unit will move if the net gains to the family are positive. The optimal choice for a member of the family may not be optimal for the family unit (and vice versa). Tied stayer: someone who sacrifices better income opportunities elsewhere because the partner is better off in the current location Tied mover: someone who moves with the partner even though his or her employment outlook is better in the current location. 2016 McGraw-Hill Education. All Rights Reserved. 10

Tied Movers and Tied Stayers A Y -10,000 F B Private Gains to Husband ( PV H ) -10,000 10,000 E C 10,000 X D PV H + PV W = 0 Private Gains to Wife ( PV W ) If the husband were single, he would migrate whenever ΔPV H > 0 (A, B, and C). If the wife were single, she would migrate whenever ΔPV W > 0 (C, D, and E). The family migrates when the sum of the private gains is positive (B, C, and D). In D, the husband would not move if he were single, but moves as part of the family, making him a tied mover. In E, the wife would move if she were single, but does not move as part of the family, making her a tied stayer. 2016 McGraw-Hill Education. All Rights Reserved. 11

Immigration in the United States There has been a resurgence of immigration to the United States in recent decades. The United States receives the largest immigrant flow in the world. The mix of countries of origin has changed substantially over time. In the 1950s, 6% of immigrants came from Asia. Presently, 31% of immigrants come from Asia. 2016 McGraw-Hill Education. All Rights Reserved. 12

Number of legal immigrants (in millions) Legal Immigration to the U.S. By Decade, 1820-2010 12 10 8 6 4 2 0 1810s 1830s 1850s 1870s 1890s 1910s 1930s 1950s 1970s 1990s Decade 2016 McGraw-Hill Education. All Rights Reserved. 13

Immigrant Performance in the U.S. Labor Market Immigrants who can adapt well and are successful in new jobs make a significant contribution to economic growth. The economic impact of immigration depends on the skill composition of the immigrant flow. 2016 McGraw-Hill Education. All Rights Reserved. 14

The Decision to Immigrate Skills vary across country-of-origin (or source country) immigrant groups. The general rule: Workers decide to immigrate if U.S. earnings exceed earnings in the source country. The decision ultimately depends on individual skills and the returns to those skills in the source and destination countries. 2016 McGraw-Hill Education. All Rights Reserved. 16

Cohort Effects and the Immigrant Age- Earnings Profile Dollars P Q R R* C Q* P* C P Q R 1960 Wave 1980 Wave and Natives 2000 Wave The crosssectional ageearnings profile erroneously suggests that immigrant earnings grow faster than those of natives. 20 40 60 Age 2016 McGraw-Hill Education. All Rights Reserved. 17

Log wage gap The Wage Differential between Immigrants and Native Men at Time of Entry 0-0.1-0.2-0.3-0.4 1955-1959 1965-1969 1975-1979 1985-1989 1995-1999 2005-2009 Year of entry 2016 McGraw-Hill Education. All Rights Reserved. 18

Log Wage Gap Evolution of Wages for Specific Immigrant Cohorts over the Life Cycle 0-0.1 Arrived in 1965-69 Arrived in 1975-79 -0.2-0.3 Arrived in 1985-89 Arrived in 1995-99 -0.4 1970 1980 1990 2000 2010 Year 2016 McGraw-Hill Education. All Rights Reserved. 19

The Roy Model The Roy model considers the skill composition of workers in the source country. Positive selection: immigrants who are very skilled do relatively well in the U.S. Negative selection: immigrants who are unskilled do relatively well in the U.S. The relative return to skills determines the skill composition of the immigrants from different source countries. 2016 McGraw-Hill Education. All Rights Reserved. 20

The Distribution of Skills in the Source Country Frequency Negatively-Selected - Immigrant Flow Positively- - Selected Immigrant Flow sn sp Skills The distribution of skills in the source country gives the frequency of workers in each skill level. If immigrants have above-average skills, the immigrant flow is positively selected. If immigrants have below-average skills, the immigrant flow is negatively selected. 2016 McGraw-Hill Education. All Rights Reserved. 21

The Self-Selection of the Immigrant Flow Dollars Dollars Positive Selection U.S. Source Country Source Country U.S. Do Not Move Move Move Do Not Move s P Skills s N Skills (a) Positive selection (b) Negative selection 2016 McGraw-Hill Education. All Rights Reserved. 22

Policy Application: Economic Benefits of Migration The immigrant surplus is a measure of the increase in national income that occurs as a result of immigration. (The surplus accrues to natives.) Immigration raises national income by more than it costs to employ immigrants. 2016 McGraw-Hill Education. All Rights Reserved. 23

Dollars Policy Application: Economic Benefits of Migration A w 0 w 1 0 F S B N S C M D Employment Prior to immigration, there are N native workers in the economy and national income is given by the trapezoid ABN0. Immigration increases the labor supply to M workers and national income is given by the trapezoid ACM0. Immigrants are paid a total of FCMN dollars as salary. The immigration surplus gives the increase in national income that accrues to natives and is given by the area in the triangle BCF. 2016 McGraw-Hill Education. All Rights Reserved. 24

The Impact of a Decline in U.S. Incomes Dollars Dollars U.S. Source Country Source Country U.S. s P Skills s N s N Skills (a) Positive selection (b) Negative selection 2016 McGraw-Hill Education. All Rights Reserved. 25

Decline in U.S. Incomes The previous graphs shows that when U.S. incomes decrease (shift down in the returnsto-skills curve): Fewer workers migrate to the U.S. The type of selection (positive vs. negative) doesn t change. 2016 McGraw-Hill Education. All Rights Reserved. 26

Relative Wage, 2nd Generation, 2000 Earnings Mobility between 1st and 2nd Generations of Americans, 1970-2000 0.5 0.4 0.3 0.2 0.1 0-0.1-0.2 Belgium Brazil India Switzerland Chile Greece Israel Poland Trinidad and Tobago USSR China Ireland Austria Korea Czechoslovakia Argentina Latvia Australia West Indies Panama Italy Yugoslavia England Jamaica Canada Germany Nicaragua Lithuania Hungary Pacific Islands Finland France Cuba Netherlands Colombia Sweden Philippines Japan Spain Denmark Ecuador Peru Norway El Salvador Costa Rica Dominican Republic GuatemalaHaiti RomaniaTurkey Honduras Mexico -0.3-0.5-0.4-0.3-0.2-0.1 0 0.1 0.2 0.3 0.4 Relative Wage, 1st Generation, 1970 2016 McGraw-Hill Education. All Rights Reserved. 27

Job Turnover: Stylized Facts Newly hired workers tend to leave their jobs within 24 months of being hired, while workers with more seniority rarely leave their jobs. The rate of job loss is highest among the least educated workers. 2016 McGraw-Hill Education. All Rights Reserved. 28

Job Turnover: Stylized Facts There is a strong negative correlation between a worker s age and the probability of job separation. This fits with the hypothesis that labor turnover can be an investment in human capital. Older workers have a smaller payoff period to recoup the costs associated with job search. Thus, they are less likely to search (or move). 2016 McGraw-Hill Education. All Rights Reserved. 29

The Job Match Each particular pairing of a worker and employer has its own unique value. Workers and firms might improve their situation by shopping for a better job match. Efficient turnover is the mechanism by which workers and firms correct matching errors and obtain a better and more efficient allocation of resources. 2016 McGraw-Hill Education. All Rights Reserved. 30

Specific Training and Turnover When a worker receives specific training, his productivity improves only at the current firm. This implies there should be a negative correlation between the probability of job separation and job seniority. As age increases, the probability of job separation decreases. 2016 McGraw-Hill Education. All Rights Reserved. 31

Job Turnover and the Age-Earnings Profile Young people who quit often experience substantial increases in their wages. Workers who are laid off often experience wage cuts. A worker s earnings depend on total labor market experience and seniority on the current job. (Workers experiencing a good job match will have low probabilities of job separation, and these workers will tend to have seniority on the job.) 2016 McGraw-Hill Education. All Rights Reserved. 32

Specific Training and the Probability of Job Separation Probability of separation Seniority If a worker acquires specific training as he accumulates more seniority, the probability that the worker will separate from the job declines over time. The probability of job separation then exhibits negative state dependence; it is lower the longer the worker has been in a particular employment state. 2016 McGraw-Hill Education. All Rights Reserved. 36

Impact of Job Mobility on the Age- Earnings Profile Wage Quit t 1 Layoff t 2 t 3 Quit Stayers Movers Age The age-earnings profile of movers is discontinuous, shifting up when they quit and shifting down when they are laid off. Long job matches encourage firms and workers to invest in specific training, and steepen the age-earnings profile. As a result, stayers have a steeper ageearnings profile within any given job. 2016 McGraw-Hill Education. All Rights Reserved. 37

God, what gorgeous staff I have. I just can t understand those who have ugly people working for them. I really can t. Just call me a pathetic aesthetic -Jade Jagger (Mick s Daughter) 2016 McGraw-Hill Education. All Rights Reserved. 2

Race and Gender in the Labor Market Men earn more than women, and whites usually earn more than nonwhites. Differences in educational attainment between whites and nonwhites account for a portion of the wage differential. 2016 McGraw-Hill Education. All Rights Reserved. 4

The Discrimination Coefficient Taste discrimination translates the notion of racial prejudice. Racial prejudice causes employers to blindly perceive the costs of hiring blacks as being higher than the true cost. Even though it costs w b dollars to hire one person-hour of black labor, the employer acts as if it costs w b (1+d) dollars, where d, d>0, is the discrimination coefficient. 2016 McGraw-Hill Education. All Rights Reserved. 5

Employer Discrimination Implication of the Becker model If blacks and whites are perfect substitutes, employers have a segregated work force. Even non-discriminating employers have a segregated work force, as they employ all black workers Discrimination does not pay. Employers hire the wrong type of worker and/or they hire the wrong number of workers. 2016 McGraw-Hill Education. All Rights Reserved. 6

The Employment Decision for a Firm That Does Not Discriminate Dollars w B E B VMP E Employment If the market-determined black wage is less than the white wage, a firm that does not discriminate will hire only blacks. It hires black workers up to the point where the black wage equals the value of marginal product of labor, E* B. 2016 McGraw-Hill Education. All Rights Reserved. 7

Dollars The Employment Decision for a Prejudiced Firm Dollars w W w B (1+d 1 ) w B (1+d 0 ) w B VMP E VMP E E W Employment E B 1 E B E B * Employment (a) White Firm (b) Black Firm Firms that discriminate can be either white firms (if the discrimination coefficient is very high) or black firms (if the discrimination coefficient is relatively low). A white firm hires white workers up to the point where the white wage equals the value of marginal product. A black firm hires black workers up to the point where the utility-adjusted black wage equals the value of marginal product. Firms that discriminate hire fewer workers than firms that do not discriminate. 2016 McGraw-Hill Education. All Rights Reserved. 8

Profits and Discrimination Dollars MAX W 0 Black Firms d W White Firms Discrimination Coefficient Discrimination reduces profits in potentially two ways. A discriminatory firm that hires only white workers will hire too few workers at a very high wage. Even a discriminatory firm that only hires black workers is harmed by its actions as it hires too few workers. 2016 McGraw-Hill Education. All Rights Reserved. 9

The Black-White Wage Ratio in the Labor Market Employer discrimination generates a wage gap between equally skilled black and white workers. The quantity demanded for black labor increases as the black-while wage ratio falls. 2016 McGraw-Hill Education. All Rights Reserved. 10

Determination of Black/White Wage (w B /w W ) Black-White Wage Ratio (w B /w W ) * 1 R 0 Ratio in the Labor Market N S D D Black Employment If the black-white wage ratio is very high, no firm in the labor market will want to hire blacks. As the blackwhite wage ratio falls, more and more firms are compensated for their disutility and the demand for black workers rises. The equilibrium blackwhite wage ratio is given by the intersection of supply and demand, and equals (w B /w W )*. If some firms prefer to hire blacks, they would be willing to hire blacks even if the blackwhite wage ratio exceeds 1, shifting the demand curve up to D. If the supply of blacks is sufficiently small, it is then possible for the black-white wage ratio to exceed 1. 2016 McGraw-Hill Education. All Rights Reserved. 11

Employee Discrimination Employee discrimination does not generate a wage differential between equally skilled black and white workers. Employee discrimination does not affect the profitability of firms. Work places will be segregated 2016 McGraw-Hill Education. All Rights Reserved. 12

Customer Discrimination If customers discriminate, their perceived price of a good is utility-adjusted with a discrimination coefficient. When a firm cannot hide black workers, customer discrimination can have an adverse effect on black wages. 2016 McGraw-Hill Education. All Rights Reserved. 13

Statistical Discrimination Statistical discrimination is based on treating an individual on the basis of membership in a group and knowledge of that group s history. 2016 McGraw-Hill Education. All Rights Reserved. 14

The Impact of Statistical Discrimination on Wages Dollars Dollars White White Black Black T * Test Score T Test Score (a) Whites have higher average score (b) Test is better predictor for white workers The worker s wage depends not only on his own test score, but also on the mean test score of workers in his racial group. (a) If black workers, on average, score lower than white workers, a white worker who gets a score of T* earns more than a black worker with the same score. (b) If the test is a better predictor of productivity for white workers, high-scoring whites earn more than high-scoring blacks, and low-scoring whites earn less than low-scoring blacks. 2016 McGraw-Hill Education. All Rights Reserved. 15

Measuring Discrimination One possible measure of discrimination is the difference in mean wages. A better measure would compare the wages of equally skilled workers. Oaxaca decomposition: a technique that decomposes the raw wage differential into a portion related to a difference in skills and a portion attributable to labor market discrimination. 2016 McGraw-Hill Education. All Rights Reserved. 16

Measuring the Impact of Gender Discrimination on the Wage Dollars w M w F M w F F Men s Earnings Function Women s Earnings Function The average woman has s F years of schooling and earns w F. The average man has s M years of schooling and earns w M. Part of the wage differential arises because men have more schooling than women. If the average woman was paid as if she were a man, she would earn w* F. A measure of discrimination is then given by w* F w F. s F s M Schooling 2016 McGraw-Hill Education. All Rights Reserved. 17

Policy Application: Determinants of the White-Black Wage Ratio There has been an upward trend in the wages of blacks in recent years. This has been attributed to increases in the quality and quantity of black schooling. Government programs have positively affected black wages. 2016 McGraw-Hill Education. All Rights Reserved. 18

The Oaxaca Decomposition of the Black-White Wage Differential, 1995 Controls for Differences in Education, Age, Sex, and Region of Residence Controls for Differences in Education, Age, Sex, Region, and Occupation and Industry Raw log wage differential -0.211-0.211 Due to differences in skills -0.082-0.144 Due to discrimination -0.134-0.098 Source: Joseph G. Altonji and Rebecca M. Blank, Race and Gender in the Labor Market, in Orley Ashenfelter and David Card, editors, Handbook of Labor Economics, vol. 3C, Amsterdam: Elsevier, 1999, Table 5. The log wage differential between any two groups can be interpreted as being approximately equal to the percentage wage differential between the groups. 2016 McGraw-Hill Education. All Rights Reserved. 19