Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

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All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 14: Markets for Labor

Figure 14.1: People Dancing at a Concert [1]​

This video of Woodstock 2011 shows an aerial view of over 700,000 people. 

While this is impressive, it wasn’t the largest crowd gathered for a concert or music festival. That honor goes to Jean-Michel Jarre’s performance in Moscow in 1997 and Sir Rod Stewart’s performance in Rio de Janeiro in 1994. It is estimated that both musicians had 3,500,000 people in attendance for each of their concerts. Jean-Michel Jarre is still considered a superstar musician and also has the honor of being one of the highest-paid musicians in the world. His earnings for 2016 are estimated to be $82,000,000.

14.1 Objectives

After reading this chapter and completing the questions and exercises, you should be able to:

  • Explain how incomes and wages are determined in most markets
  • Explain the effects of a change in productivity of labor
  • Show why some individuals earn more than others even when their skills are identical
  • Explain how labor unions influence wages
  • Discuss why superstars earn so much, while others with similar skills earn so little

In this chapter, we explore how wages and incomes are determined, what causes some individuals to earn more than others, what causes individuals with similar skills to earn varying amounts, and the role of unions in influencing labor markets. Most individual incomes are earned from jobs in the form of wages and salaries. In fact, seventy percent of all income is earned as wages and salaries. How those wages and income are determined is of interest to all of us.

We will begin with a supply and demand model to explain why people earn different wages or income. Our explanation of human capital and its role will help explain how differences among people explain part of the variation in wages, but much of our discussion will focus on explaining why people with similar skills and backgrounds earn differing amounts.

Wages have grown over time; more highly skilled individuals earn more than individuals with fewer skills; college graduates earn more than those with only a high school education; and women on average earn less than men. Developing an ability to explain why all this is true is the goal of this chapter.

14.2 Changes in Incomes

The wages and income we earn from jobs are determined, not surprisingly, in markets for labor. For instance, nominal (not adjusted for inflation) wages have grown from $2.09 per hour in 1964 to over $27 per hour in 2019. Figure 14.2 below shows the level of wages and incomes through time, again not adjusted for inflation.

ECN14_figure14.2_updated.jpg
Figure 14.2: Indexes of Median Nominal Wages and Average Income per Person Over Time in Current Period Dollars.

In Figure 14.2 above, the teal line shows how income has changed through time while the red line shows how wages have changed through time. Notice that both lines trend upwards, but income is rising faster than wages. Also, notice how wages and income appear to have grown rapidly from 1980 to 2018. These lines have not been adjusted for inflation. Shortly, we will see how adjusting for inflation compares to this graph.

Not only have wages and income changed over time, but wages also differ dramatically among professions. Table 14.1 below shows annual incomes across a range of professions.

ECN14_table14.1_updated.jpg
Table 14.1: Data from the Bureau of Labor Statistics.

Table 14.1 above shows that physicians earn more than ten times the mean wage of a fast food cook. Physicians earn more than veterinarians. Police officers earn more than elementary school teachers. Firefighters earn more than taxi drivers. Why? An easy explanation might be that some professions require different levels of education. But could there be other reasons why wages and incomes vary across industries? These questions will be addressed in this chapter.

In 2017, the Census Bureau reported that the poverty rate in the USA was 12.3 percent. This means that 39.7 million Americans live in poverty. A major goal of economic policy in the US and around the world is to reduce poverty rates. Understanding why some workers earn high wages and some earn low wages is essential to reducing poverty. 

ECN14_figure14.3_updated.jpg
Figure 14.3: The data for 2013 and beyond reflect the implementation of the redesigned income questions. The data points are placed at the midpoints of the respective years.

Looking at Figure 14.3 above, we can see how poverty has changed through time. The top graph in blue shows poverty as the total number of people in poverty. This graph can be misleading since the population of the United States has grown over time and increased poverty could in part be from the increased population. The bottom graph in green shows the poverty rate as a percentage of the population. It shows that the poverty rate fell substantially between 1959 and the early 1970s but have fluctuated between 10 and 15 percent since then.

14.3 Definitions of Wages

Figure 14.2 indicates that wages have increased dramatically over the last 35 years. Much of this growth is due to rises in the price of everything, including wages. Recall from chapter 3 that when inflation is positive, as it typically is, the price of a basket of goods rises over time. So, if wages are increasing, does this necessarily mean that workers are better off? The answer isn’t clear since a dollar buys less stuff today than it did 35 years ago. 

 A more meaningful way to compare wages over time is to adjust them for inflation and use what economists refer to as real wages. Real wages are wages paid (often referred to as the nominal wage or just simply wages) adjusted for inflation. The idea is to hold the value of a dollar constant. This way, when real wages increase, we know it means that increases in the nominal wage were large enough that workers could afford the same bundle of goods as before and have money left over for other purchases. 

 To reinforce the concept of real wages, let’s use an example. Suppose that weekly wages are $100 and you purchase 100 bananas at $1 each. A few years pass and your wages are $200, and bananas are $1.50 each. Although your nominal wage doubled, you cannot afford twice as many bananas as before. However, you can buy your 100 bananas for $150 have $50 extra dollars to spend on other goods. Your real wages have increased by more than the price increase on bananas. Simply stated, an increase in real wages means you can buy more than you did before.

Below, Figure 14.4 shows nominal wages and income and real wages and income. The flatter, less dramatic lines show the change in real wages and income through time. Generally, nominal wages and income grow faster than real wages and income because prices generally rise. 

ECN14_figure14.4_updated.jpg
Figure 14.4: Recall these numbers are indexed to compare the changes through time. The bottom two lines show real wages and income growth through time, which are not as dramatic nor as high as the nominal values show.

In common usage, wages most often refer to the money paid to a worker. However, most workers receive additional compensation in the form of fringe benefits such as health insurance, sick pay, retirement benefits, and days off for vacation. These days, fringe benefits are not trivial, as they make up an average of almost 30 percent of total income. Because these are benefits to a worker and a cost to an employer, they should be included in our analysis of labor markets. In the analysis that follows, the price of labor should include all of the direct and indirect payments made in exchange for working. 

Question 14.01

What is the difference between nominal and real wages?

A

Real wages include fringe benefits while nominal wages do not include fringe benefits.

B

Real wages do not include fringe benefits while nominal wages include fringe benefits.

C

Nominal wages have been corrected for inflation, and real wages are not corrected for inflation.

D

Nominal wages have not been corrected for inflation, and real wages are corrected for inflation.

14.4 A Preview of Markets for Labor

Our goal is to understand why wages vary over time and across different jobs, countries, and groups of people. Having studied supply and demand for goods and services, you already have the tools to provide at least a superficial explanation of why wages may be high for one profession and low in another. The first step is to realize that the roles businesses and individuals fulfill in the labor market are the reverse of their roles in the markets for good and services. In markets for goods and services, firms supply the products and individuals demand them. Here, individuals supply the labor, and it is the firms that demand labor.

Figure 14.5 below depicts a hypothetical labor market under two scenarios. In both scenarios, the demand for labor is the same. Using this graph, explain in very general terms, what is it that would cause wages to be relatively high or relatively low?

Figure 14.5: Changes in Wages Due to Supply and Demand for Labor​

Figure 14.6 illustrates another general explanation for differences in wages. Here we hold the supply of labor fixed and let the demand for labor change. We can see that holding the supply of labor constant, when demand is high, workers work more and earn higher wages.  The challenge is to explain what would cause relatively high and relatively low supply or demand in the labor market. In the next two sections, we will carefully develop what determines the demand for and the supply of labor.

Figure 14.6: Changes in wages due to supply and demand for labor​

14.5 Demand for Labor

​When students and their parents purchase higher education, they indirectly increase the demand for the labor that goes into producing that education. The amount of labor hired, whether it is faculty, librarians, or college administrators, depends upon and is “derived” from the demand for education itself. Demand for labor is a derived demand – a demand that is “derived” from the demand for the goods and services produced by the workers. Consumers demand a firm’s goods and services. In turn, the firm demands labor to produce those goods and services. Consumers are not directly demanding the labor used, but they are demanding the products that are produced by that labor.

Figure 14.7 illustrates this idea by showing the market for nurses and the market for nursing teachers. An increase in demand for nurses causes a rise in their wages. The rise in wages will cause some people to seek out a career in nursing and enroll in nursing school. This, in turn, will increase the demand for teachers at nursing schools. 

Figure 14.7: With an increase in the number of students wishing to become nurses, more students go to nursing school thus increasing the demand for teachers at nursing schools. Demand 2 for teachers would be the derived demand curve.​

Graphing Question 14.01

Graphing Question 14.02

To derive the demand for labor, we start by analyzing a firm's decision to hire workers. How does a firm choose the amount of labor it will hire? Think back to the production function we first discussed in Chapter 7: Inputs, Production, and Costs as we began our discussion of profit-maximizing firms. It might help to recall what those graphs showed. One is provided for you below in Figure 14.8.

Figure 14.8: As the quantity of labor increases, total output rises. On the margin, as the quantity of labor increases, the additional output the employee creates gets smaller and smaller.​​

The graph above shows that for firms to increase production, they need to increase the amount of labor used. In this graph, we assume that the other resources labor must use – the amount of land and capital, the existing technology, and the quality of the labor itself are fixed. We measure the contribution of labor by looking at the increases in output produced by each additional worker and refer to it as the marginal product of labor. Notice that the additional contribution of a worker diminishes as the firm hires more labor. We see on the bottom left that hiring one more worker results in an increase of total output from 17 to 22 units, five more units of output. If we move further to the right, we see that hiring one additional worker caused total output to increase from 30 to 31 units, a much smaller increase of only one unit of output. This phenomenon is called the diminishing marginal productivity of labor.

Why does the marginal product of labor diminish? The idea is that adding more workers to a fixed amount of capital results in higher total output but lower marginal output per additional worker. Consider, for example, the owner of an apple orchard who hires apple pickers. The first picker hired can select all the best tools—ladder, picking tools, etc. At some point, an additional picker hired will have to use less ideal tools or possibly even share tools with others. So, even if all apple pickers have equal ability, their marginal productivity will decline. Also, management will often set priorities that affect productivity. For instance, the first accountant hired may be used to file tax returns or produce financial statements required by the government allowing the firm to avoid large government fines. The second accountant may gather data to aid management decisions – valuable work but not as valuable as complying with the law! 

To determine how many employees to hire, we need to figure out how much this additional output is worth. By taking the marginal product of labor and multiplying it by the per unit price of that output, we obtain the marginal revenue product of labor (MRP for short) or the value of the additional output created by an additional unit of labor. In our example above, suppose the firm can sell each unit of output at a price of $10. The unit of labor that increased production by five units has created $50 of additional revenue for the firm. In other words, the marginal revenue product of labor at that point on the production function is $50. What should happen to the marginal revenue product of labor as a firm increases the amount of labor it hires?

Question 14.02

Use the following chart to find the marginal revenue product of labor. Assume the market price for output is $100.

question description
Premise
Response
1

A

A

$800

2

B

B

$600

3

C

C

$200

4

D

D

$400

5

E

E

$1000

Graphing Question 14.03

Question 14.03

Question 14.03

Explain, in your own words, why the marginal product of each worker at each level of labor employed gives us a demand curve for labor.

Hover here to see the hint for Question 14.03.
Click here to see the answer to Question 14.03.

14.5.1 The Marginal Revenue Product of Labor and the Demand Curve

We are now ready to derive an individual firm's demand for labor - the amount of labor that a firm will hire for any given wage. With a little bit of marginal analysis, we will show that a firm's demand for labor is equal to that firm's marginal revenue product.

Let's consider the decision to hire an additional unit of labor. How does a profit-maximizing firm make this decision? By comparing the marginal cost to the marginal benefit of course! We will assume that the firm can hire as many workers as it wishes at the going wage. This means that the marginal cost of hiring one more worker is the wage. What is the marginal benefit of hiring one more worker? The marginal revenue product. We have determined the marginal benefit and the marginal cost of hiring a worker, so we are ready to decide whether to hire that worker.

Question 14.04

A profit-maximizing firm will hire an additional worker if which of the following is true?

A

The wage is equal to total product

B

The worker increases output

C

The marginal revenue product is greater than the wage

D

The wage is greater than the marginal revenue product


Question 14.05

When a firm holds all other inputs fixed and increases the amount of labor it employs, what will happen to the marginal revenue product of labor?

A

Marginal revenue product increases

B

Marginal revenue product will not change

C

Marginal revenue product decreases

​Question 14.06

Question 14.06

What to do if marginal revenue product is less than wage?

Hover here to see the hint for Question 14.06.
Click here to see the answer to Question 14.06.

In the questions above, we have concluded that firms will hire when MRP is more than the wage, and they will fire workers when MRP is less than the wage. We conclude then that profit-maximizing firms that hire just until wages are equal to the marginal revenue product of labor. So, here's the punchline. The amount of labor that a firm will hire at any given wage is given by that firm's MRP of labor schedule. Look at the graph you created in question 14.03. That downward sloping line is that firm's demand for labor! In other words, the demand for labor is the marginal revenue product of labor.

14.6 Market Demand

Just as in the demand for goods and services, we can calculate the market demand for a particular type of labor. When we studied markets for goods and services, we found market demand by adding the quantity demanded by all consumers at each price to get the market quantity demanded at each price. The market demand for labor works similarly. The market demand for labor is the summation of all the firms’ demand for labor at each wage. 

14.6.1 Human Capital 

​Economists recognize that people differ in their ability to produce goods and services for reasons other than the amount of physical capital they use. The productivity of a worker or an entire workforce is influenced by factors such as experience, skills, education, health, and work habits. These factors stay with the worker and may be accumulated over time with effort. Economists refer to the accumulated skills of a worker or workforce as human capital.

An increase in the amount of human capital that a worker or group of workers has will result in a higher marginal product of labor. The higher the marginal product of labor, the greater the demand for labor is. The higher the demand for labor, the greater the wage will be (assuming, of course, that everything else remains the same). One of the most effective ways for one to increase one’s wages is to increase human capital.

Question 14.07

Find the labor demanded at each wage for the market.

question description
Premise
Response
1

A

A

12

2

B

B

18

3

C

C

6

4

D

D

15

5

E

E

7

F

9

G

3

14.7 Supply of Labor

It should not be too surprising that demand tells only half of the story of how wages are determined. The supply of labor depends upon the population, the required skills, opportunity costs, taxes, wealth, and, of course, wages (or at least, the quantity supplied does). A model of labor markets assumes that quantity supplied of labor in a market depends upon changes in the levels of wage and benefits (which together make up the price of labor). In most cases, we find that the quantity supplied increases as wages rise. Higher wages in one market attract workers from other occupations or out of retirement or into the labor force.

Think of whether you would be willing to offer your services to assist in a study if the economics department offers you $2 per hour. Would you do it? What if the offer were $5 per hour? $10 per hour? $20 per hour? $30 per hour?

Question 14.08

Question 14.08

What do you predict will happen to the number of students willing to work on an economics study as the professor increases the pay? Why?

Hover here to see the hint for Question 14.08.
Click here to see the answer to Question 14.08.

Question 14.09

Match each of the following changes with the corresponding effect on the supply of labor. When one factor changes, assume nothing else changes.

Premise
Response
1

An increase in population

A

Decrease supply

2

A decrease in the necessary skills for a profession

B

Increase supply

3

A decrease in wealth

C

Increase supply

4

An increase in opportunity cost

D

Increase supply

5

Expectation that social security¸ savings¸ or pensions may not be available at retirement

E

Increase supply


Question 14.10

We can tell when the income effect dominates the substitution effect when which of the following is true?

A

Wages increase and people work more hours which means they purchase less leisure

B

Wages decrease and people work fewer hours which means they purchase more leisure

C

Wages increase and people work fewer hours which means they purchase more leisure


Question 14.11

We can tell when substitution effect dominates the income effect when which of the following is true?

A

Wages increase and people work more hours which means they purchase less leisure

B

Wages decrease and people work fewer hours which means they purchase more leisure

C

Wages increase and people work fewer hours which means they purchase more leisure


As a worker’s wage increases, he or she may work more, less, or the same number of hours. On the one hand, a higher wage raises the opportunity cost of leisure and encourages workers to substitute work for leisure – to work more hours since the rewards are greater. This is the substitution effect. On the other hand, as total income rises, at some point, a worker may decide she can now afford to work less and enjoy leisure more. This is the income effect.

The two effects, income and substitution, cause us to purchase more leisure or less leisure, respectively. The effects move us in opposite directions! As a result, if the income effect (purchase more leisure) is larger than the substitution effect (purchase less leisure), the quantity of labor supplied decreases as wages rise. Conversely ,if the substitution (purchase less leisure) effect is larger than the income effect (purchase more leisure), the quantity of labor supplied increases as wages rise.

The question is: which effect will dominate? Graphing Question 14.04 below will show a labor supply curve where workers are initially giving up leisure and working more. This trend means that the substitution effect dominates the income effect. Then there comes a point where behavior changes and people consume more leisure as their wages increase. This change means that the income effect has dominated the substitution effect.

Graphing Question 14.04

14.8 Supply and Demand

Equilibrium in a market for labor is a lot like equilibrium in a market for a good and a service. There is some wage at which the quantity of labor supplied by individuals will just equal the quantity of labor demanded by firms at that wage. Adjustment to this equilibrium works exactly like a goods and services market. Given a market supply and demand curve, you should be able to explain the process of a change in either supply or demand and the resulting movement into an equilibrium.

The primary difference will be one of time. Goods and services markets move relatively quickly in many instances. Financial markets are almost instantaneous. Labor markets are slow. It takes time to produce another engineer. It takes time to learn about open positions and wages in another industry. 

Question 14.12

Consider the supply and demand curve for engineers and for retail store clerks. The supply and demand curves will differ in each market. Which graph(s) belong to the market for store clerks?


Question 14.13

Consider the supply and demand curve for engineers and for retail store clerks. The supply and demand curves will differ in each market. Which graph(s) belong to the market for engineers?

Graphing Question 14.05

Question 14.14

Question 14.14

What happens to wages in an industry if the demand for the product decreases?

Hover here to see the hint for Question 14.14.
Click here to see the answer to Question 14.14.

Question 14.15

Question 14.15

What happens to wages in an industry if productivity of labor increases?

Hover here to see the hint for Question 14.15.
Click here to see the answer to Question 14.15.

Question 14.16

Question 14.16

What happens to wages in an industry if productivity of labor decreases?

Hover here to see the hint for Question 14.16.
Click here to see the answer to Question 14.16.

Question 14.17

Question 14.17

Consider two markets: one for elementary teachers in Riverside and the second for elementary teachers in San Bernardino. What will likely happen to wages and employment if Riverside is currently paying higher wages than San Bernardino?

Hover here to see the hint for Question 14.17.
Click here to see the answer to Question 14.17.

Question 14.18

Suppose that investment banking becomes a very fashionable career path for university graduates to follow, and more graduates try to get a job in this field. What is likely to happen to wages?

A

Wages will increase as demand increases

B

Wages will increase as supply increases

C

Wages will decrease as demand decreases

D

Wages will decrease as supply increases

E

Wages will increase as supply decreases and demand increases

Question 14.19

Question 14.19

If a firm finds that it must pay more to hire workers, it will also find that it will end up with ______________ in the marginal product of labor.

A

An increase. (Demand for workers increases.)

B

An increase. (The firms no longer find it worthwhile to hire as many workers.)

C

No change. (The wage increase will not affect the marginal product of labor. The reverse is true.)

D

A decrease. (Supply of workers increases.)

E

A decrease. (Supply of workers decreases.)

Click here to see the answer to Question 14.19.


14.9 Compensating Differentials

In some cases, individuals in similar occupations seem to be earning different wages, even though the occupations or jobs appear to require the same skills. If the occupations are so close and perhaps even identical in terms of demand, why won’t the wages automatically be identical? 

Consider the market for elementary school teachers in two different suburbs of Los Angeles: San Bernardino and Riverside. The forces of supply and demand described above would seem to result in similar wages in the two locations. What might prevent San Bernardino teachers' wages from equaling Riverside teachers' wages?

Figure 14.9: Supply and demand for teachers in Riverside​


Figure 14.10: Supply and demand for teachers in San Bernardino​

In Figure 14.9 above, we see that the equilibrium wage is $15.00, while the equilibrium wage in Figure 14.10 is $20.00. Both figures exhibit the same demand curve. If Riverside is a more desirable place to work than San Bernardino, it may be that teachers are willing to work for a lower wage in Riverside if they prefer to live there. In that case, compared to San Bernardino, the supply of teachers will be greater in Riverside, the wages will be lower, and the quantity hired greater.

An unskilled construction worker earns less than a garbage collector, and both earn more than a sales clerk, yet the skills required may not be significantly different (or at least the cost of acquiring those skills is similar). If the requirements are similar, then why won’t workers move from sales clerk positions to construction work and then on to garbage collection?

The answer comes from factors influencing the decision. If the job of garbage collector is less desirable than working as a construction worker and working inside in air conditioning is still more desirable than construction work, then some individuals will be more interested and willing to work in sales than in construction or garbage collection. Thus, the labor supply of sales clerks is greater, and the wages are lower than that of construction workers and garbage collectors. The same is true for construction relative to garbage collection. Even though the jobs may indeed require similar skills and training, they are not perfect substitutes. The garbage company will pay a higher wage, and that increase is often described as a compensating differential.

Graphing Question 14.06


Question 14.20

If a compensating differential exists, this means what?

A

Wages will be similar since the jobs are similar

B

One wage will be higher than the other because the job with lower wages has more desirable working conditions

C

The supply of the more desirable job, which has lower pay, has a relatively lower supply than the job with less desirable working conditions

D

The demand for the more desirable job is higher than the job with the less desirable working conditions

Question 14.21

Question 14.21

Suppose that you graduate with an accounting degree and have two job offers. Both pay the same wage and have the same working conditions and future. The first is in the Mohave Desert in a town of 10,000. The second is in Chicago or Atlanta – your choice. Which one will you take? If most others make the same choice, what will be the effects in the labor markets?

Hover here to see the hint for Question 14.21.
Click here to see the answer to Question 14.21.

Question 14.22

Question 14.22

Why do nonprofit organizations tend to pay less for secretaries and executives when compared to incomes for very similar work done at profit-making organizations?

Hover here to see the hint for Question 14.22.
Click here to see the answer to Question 14.22.

14.10 Discrimination

Women with similar skills and education as males earn between 70 and 80 percent of what males earn in the same positions (see Figure 14.11). African-Americans, on average, earn a similar portion of whites’ income. Differences in the amounts of human capital and the existence of compensating differentials explain part of the differences in average wages of males and females and whites and African-Americans, but not all of the differences. In some instances, the difference in wages may be due to differences in amounts of education and job experience. For example, a woman who takes time out of the job market to have a child may have less relevant experience than a male who has not taken time out. The wage difference may reflect the resulting difference in human capital. The demand is lower, as a result, causing a lower wage. 

ECN14_figure14.11_updated.jpg
Figure 14.1: The upper graph shows women's wages compared to men's wages. Converting the values into percentages makes them much easier for us to interpret. The 80.5 percent we see in year 2017 means that for every $1.00 a man earns, a woman earns $0.85. The graph shows that women's wages began at $0.60 per $1.00 of men's wages in the early 1960s, and the wage differential has gotten smaller through time but still exists.

While differences in human capital might explain some of the difference between these groups, in other cases, employers may discriminate against females, African-Americans, or others either because they incorrectly believe they are less productive than white males or because the employers simply do not want to work with a particular group of people. In either case, the group that is discriminated against ends up with lower wages and less employment. In one of the questions below, we will explore how competitive markets have the power to alleviate some of the suffering caused by discrimination.

Question 14.23

Assume the market begins in equilibrium as shown on the graph. Which of the following graphs shows a labor market where workers face discrimination? (Assume Demand 1 is for workers who do not face discrimination and Demand 2 is for those who do.)

Question 14.24

Question 14.24

Why would a perfectly competitive firm be able to increase profit when discrimination exists and, as a result, reduce the effects of the discrimination?

Hover here to see the hint for Question 14.24.
Click here to see the answer to Question 14.24.

Question 14.25

Question 14.25

Sometimes it is not a change in demand for two types of labor that causes differences in market outcomes. Suppose that women are prevented from entering most professions – except perhaps teaching and nursing. What is likely to happen to wages in those two professions as a result?

Hover here to see the hint for Question 14.25.
Click here to see the answer to Question 14.25.

Question 14.26

Question 14.26

if the job barriers for women were removed from all jobs and the wages of teachers and nurses did not adjust quickly, what would happen the market equilibrium for teaching and nursing?

Hover here to see the hint for Question 14.26.
Click here to see the answer to Question 14.26.

14.11 Labor Unions

Figure 14.12: Cesar Chavez was an influential American labor leader. Today he is a symbol of grassroots efforts and Hispanic empowerment. [2]​

 ​In response to undesirable wages and working conditions, labor unions have often formed to negotiate with firms and industries for better working conditions and wages. Unions are found throughout manufacturing industries, such as the automobile industry, the construction industry, the airline industry, and many levels of government. Some unions organize according to skills, as in carpentry or printing, while others organize across industries and include individuals with different skills, like steelworkers and government workers.


Cesar Chavez championed for workers’ rights. To see a mini-biography of his life, view the video above. 

The efforts of labor unions are significantly less important in the economy today than throughout much of the twentieth century. In 2016, American workers in unions were slightly more than 10 percent. Fifty years ago, 25 percent of workers were union members.

Most research concludes that the effect of a union is to raise wages for their members an average of 15 percent above what they would otherwise be. (The effects on non-union members tend to be very different, as discussed below.) There are several ways in which unions operate to raise wages. The most common and prevalent method has been an approach that changes the supply of labor. By forming unions and restricting membership, the workers reduce the supply of labor and cause wages to increase. Without the reduction in supply, increasing wages would potentially be doomed to failure. The craft unions of carpenters, plumbers, teachers, steelworkers, and pilots have all functioned in such a way that causes the supply of labor to be limited in that particular field.

An alternative approach for unions, which is much less effective and not often used, is to increase demand. Musicians have pushed for requirements for a minimum size of orchestras. Steelworkers have favored tariffs on steel since tariffs increase the demand for domestic steel. Clothing workers have spent union funds to encourage consumers to purchase clothing manufactured by unions. Some research has shown that unions are able to increase productivity through increased communication and greater incentives to work hard and be more productive. When workers are more productive, each worker is able to produce more output. In other words, the worker’s marginal productivity increases! When workers can produce more output per worker hired, firms will demand more labor.

Let’s reinforce the last point with what we have learned so far.

Question 14.27

What is the equation to determine the number of workers a firm should hire?

A

Marginal productivity of labor = wages

B

Price x (marginal productivity of labor) = wages

C

Marginal productivity of labor = marginal revenue

D

Marginal revenue = marginal productivity of labor

Question 14.28

Question 14.28

What does the equation, W = Marginal revenue product of labor mean in words?

Hover here to see the hint for Question 14.28.
Click here to see the answer to Question 14.28.

Question 14.29

Use the table provided to determine how many workers a firm will hire if the price of output is $500 and the wage is $1000 per worker.

question description
A

1

B

2

C

3

D

4

E

5

Question 14.30

Question 14.30

From the prior question, explain the logic of the equilibrium solution you found.

Hover here to see the hint for Question 14.30.
Click here to see the answer to Question 14.30.

Question 14.31

Assume that the price of output is $100 and the wage is $500 per worker. Use the following table to find the marginal revenue product of labor to determine how many workers to hire.

How many workers will the firm hire?

question description
A

2

B

3

C

4

D

5

Question 14.32

Question 14.32

From the prior question, explain in words what process the firm uses to decide to go from 4 to 5 employees hired.

Hover here to see the hint for Question 14.32.
Click here to see the answer to Question 14.32.

Question 14.33

Question 14.33

Can you determine the effect of a new union in formerly nonunion labor markets?

Hover here to see the hint for Question 14.33.
Click here to see the answer to Question 14.33.

Graphing Question 14.07

14.12 Winner-Take-All Labor Markets

Among rock and rap stars, fiction writers, movie actors, Wall Street investment bankers, Fortune 500 chief executive officers, and sports stars, small differences in talent and skills can make huge differences in income. Struggling movie actresses, who are potentially as talented and attractive as Rihanna, Scarlett Johansson, Jennifer Lawrence, and Ryan Gosling are working as waiters and earning not much more than minimum wage while going to auditions. Yet Rihanna, Johansson, Lawrence, and Gosling are receiving several millions of dollars for each film or record.

Recall the quote at the beginning of the chapter regarding people who aspire to pop careers, with one becoming Whitney Houston and the rest waiting tables. Or Jean-Michel Jarre, who was the highest paid musician in 2016. He is a superstar and a winner in a winner-take-all market. He also has a high marginal product. His labor, singing, has very high marginal productivity per concert. Since his productivity is so high, he can command a large income.

Additionally, modern technology means that in many industries the services of a worker can be distributed at very low cost to very large numbers of customers. In the music industry, it does not take much to produce a DVD version of a performance once the master recording is produced. If an unknown performer is hired and recorded, the music publishing company may promote that person and make significant economic profits. If indeed that happens, other publishers will bid for those services. This makes a performer valuable and increases his or her wages.

Question 14.34

Question 14.34

For every professional basketball and baseball player, there are hundreds, if not thousands, of players who are almost as good and they are struggling in the minors at extremely low income. Why?

Hover here to see the hint for Question 14.34.
Click here to see the answer to Question 14.34.

When all baseball players or all actors and musicians are on small stages, their incomes are not going to be universally high. However, when the stages are big – that is, they are performing in front of millions of people – their marginal products will be very high. Thus, their income will be high.

Is this good or bad? People demand their services and are willing to pay for super talent. The fact that those goods and services are meeting wants that people are willing to pay for is good.

However, think back to the opening paragraph of the chapter. One of the disadvantages is that we may be using more resources to get the superstar output than makes sense. On the other hand, those musicians and actors who earn little in their desired profession and must supplement their income as waiters may be much happier doing that than being building managers full-time and giving up on their art. If so, their gain would at least partially offset any loss to society. Is there a solution? That is a tough problem to solve.

Question 14.35

Discrimination in a labor market will result in which of the following changes in profits?

A

Profits will not change. Discrimination has nothing to do with prices and costs.

B

Profits will decrease. The firm will be hiring many workers where the marginal revenue product is greater than the wage.

C

Profits will increase. The demand for the firm’s product will increase.

D

Profits will decrease. The firm will be hiring many workers where the marginal revenue product is less than the wage.

E

Profits will increase. The demand for the firm’s product will decrease. Hint: Think on the margin.


Question 14.36

If a union reduces supply of workers for a group of firms, what would you expect to happen to wages paid by those firms and wages paid by nonunion firms?

A

Union wages will increase, and nonunion wages will increase.

B

Union wages will increase, and nonunion wages will decrease.

C

Union wages will decrease, and nonunion wages will increase.

D

Union wages will decrease, and nonunion wages will decrease.

E

Union wages will increase, and nonunion wages will not change.


Question 14.37

Does the best singer earn the same as the next-best person, less than, more than, or a significantly larger amount?

A

The same

B

Less than

C

More than

D

Significantly more than

14.13 Summary

  • Demand for labor will change with fluctuations in the productivity and with the prices of the good or service produced. If the productivity increases and the price of the good increases, the demand for labor will increase. 
  • The supply of labor is much like a normal supply curve for a good or service. Supply increases and decreases with changes in population, opportunity cost, working conditions, unionization, and necessary skills of workers.
  • Increases in wages cause the quantity of labor demanded to decrease.
  • Increases in wages cause the quantity of labor supplied to increase.
  • At an equilibrium wage, the wage equals the marginal revenue product of labor.
  • An increase in the price of the product or an increase in the marginal product of workers will increase demand for workers, which will cause an increase in the equilibrium wage. Decreases will have the opposite effects.
  • A decrease in supply will increase wages and lower employment; an increase in supply will decrease wages and increase employment. Differences in the desirability of working conditions, discrimination, and the role of labor unions can cause changes in supply and thus differences in wages among markets.

14.14 Key Concepts

Compensating differentials

Demand for labor

Derived demand

Equilibrium wage

Human capital

Marginal product of labor

Marginal revenue product of labor

Nominal wages

Real wages

Supply of labor

Marginal product

Winner-take-all markets

14.15 Glossary

Compensating differential: A difference in the wages of jobs with similar skill requirements when the cause is that something about the position makes it less attractive than alternative positions.

Demand for labor: The quantity of labor demanded at each wage rate. Derived from the marginal revenue product at each level of employment.

Derived demand: Demand that is derived from the demand for something else. The demands for inputs into the production process are derived from the demand for the goods and services that they produce.

Human capital: The factors such as experience, skills, education, and work habits that affect the value of a worker’s marginal product.

Labor union: A group of workers who have organized in an effort to increase wages and improve working conditions.

Marginal revenue product of labor: The increase in revenue resulting from the hiring of one additional worker.

Nominal wages: The wages workers are paid without adjusting for inflation.

Real wages: The nominal wage adjusted for the effects of inflation.

Supply of labor: The quantity of labor that workers are willing to supply at each wage level.

Wages: The amount paid workers, usually including fringe benefits such as health insurance, retirement, and vacation.

Winner-take-all markets: Top performers earn high income, while others, who may be almost as good, earn significantly less.





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Answer Key

Answer to Question 14.03

Use the graph above. When the firm is deciding whether they should increase their workers from one to two workers, they should look at the cost of the additional worker and the value the additional worker creates. The additional worker creates a value of $800, and the wage we are willing to pay is $800. This is not the market wage. It is only the most we are willing to pay the additional worker. It means that to hire the additional worker, he or she needs to create value that at minimum covers the cost of hiring the worker. This logic follows for each additional worker hired. This entire process is much like the cost/benefit comparisons we have done throughout the course. The firm, attempting to maximize profits, compares the benefits of hiring one more worker (the marginal revenue product of labor) with the costs of hiring that worker (the wage). As long as the additional benefits are greater than the additional costs, the firm expands its production by hiring more workers. The expansion causes the marginal product to fall, and eventually, the marginal revenue product of labor equals the wage. The firm stops expanding its hiring of workers at that point. It would make no economic sense to expand beyond, as the cost of the decision would be greater than the benefits.

Click here to return to Question 14.03.






Answer to Question 14.06

This firm could increase profits by reducing the amount of labor it employs. The firm's wage expense would fall by more than its revenue so it should release some workers. By doing this, marginal revenue product will rise as the remaining workers are more productive than the ones that were released. The firm will continue to reduce the amount of labor it employs until marginal revenue product is equal to the wage.

Click here to return to Question 14.06.












Answer to Question 14.08

How would you and your classmates decide whether to work for the economics department? Your decision to work means that you are going to have to give up something, whether it is working at another job, going to a movie, or listening to music. There is an opportunity cost. Most individuals will compare the wage paid by the economics department to what they could earn elsewhere or the amount of enjoyment they are going to have to give up. Once the wage is high enough that it provides greater satisfaction than what must be given up, the decision will be made to work. Thus, we end up with an upward sloping supply of labor. As the wage increases, work in the economics department is substituted for other work or for leisure.

Click here to return to Question 14.08.











Answer to Question 14.14

If demand for a product decreases, the price of the product will fall. Because the marginal revenue product of labor at each level of hiring is the marginal product of labor times the price of the product produced, the marginal revenue product of labor will fall. The marginal revenue product of labor will then be less than the cost of hiring the last laborer hired. This means that the worker costs the firm more than he or she creates revenue. This is a loss of profit. The labor demand falls, and a new equilibrium is found between the supply and demand with lower wages.

Click here to return to Question 14.14.











Answer to Question 14.15

This is the same as an increase in demand for labor. Why? If productivity increases, the marginal product of labor at each level of hiring increases and thus the marginal product of labor is greater than the cost of hiring another laborer. In other words, when productivity rises, all workers create more output. Since output has increased, this means the marginal revenue per worker increases. Now the quantity demanded of labor increases at each wage, thus the demand for labor increases. Given the increase in demand, there will be a shortage of labor, the wage rate will be bid up until it reaches a new higher equilibrium, and more workers will be hired.

Click here to return to Question 14.15.











Answer to Question 14.16

This is the same as a decrease in demand for labor. If productivity decreases, the marginal product of labor at each level of hiring decreases and thus the marginal product of labor decreases. This means for the last worker hired that his output has decreased which means his marginal product and marginal revenue product has decreased. Now the worker is paid more than the value he creates. The quantity demanded of labor decreases at each wage, thus a decrease in the demand for labor results. Given the decrease in demand, there will be a surplus of labor, the wage rate will fall until it reaches a new higher equilibrium, and fewer workers will be hired.

Click here to return to Question 14.16.











Answer to Question 14.17

If Riverside is paying a lower average wage than San Bernardino, and everything else about the positions is the same, it is likely that some teachers will leave Riverside and apply for positions in San Bernardino. The supply of teachers in Riverside will fall, increasing the lower wage and reducing the number of teachers hired. The supply of teachers in San Bernardino will increase, so the wages in San Bernardino will likely fall and the quantity hired will increase. The wages should eventually approach equality if everything else about the positions is the same.

Click here to return to Question 14.17.












Answer to Question 14.19

When labor costs increase, firms hire fewer workers. As this occurs, the marginal productivity of labor increases. This is most easily seen by drawing a labor demand curve. Don’t shift the curve, but move along the curve. Wages will rise. As the quantity of labor falls, the total output decreases. The following graph shows the increase in marginal revenue product of labor. 

Click here to return to Question 14.19.







Answer to Question 14.21

The more desirable job is likely the one in Chicago or Atlanta.  This creates a higher supply of labor for the cities.  If all other things equal, and all graduates have the same attitudes, it is likely that the wage rate in the Mohave Desert will be higher than in Chicago or Atlanta due to labor supply differences.  However, it is also likely that there is a higher demand for labor in the cities compared to the desert.  If that is the case, this higher demand would increase city wages relative to desert wages.  Remember to consider both labor supply and demand when thinking about wages.

Click here to return to Question 14.21.












Answer to Question 14.22

If the marginal revenue products are the same, then the difference in income must be due to a difference in the willingness of individuals to work in nonprofit organizations and for-profit companies. If people are willing to accept a lower pay for their work, the supply curve could be very flat for non-profit firms.

 If the marginal revenue products are different, with the for-profit values being greater, that too can explain the difference in income.

Click here to return to Question 14.22.











Answer to Question 14.24

In a market equilibrium with discrimination, the actual marginal product of labor is greater than the wage being paid to individuals facing discrimination. So, if firms can hire a great female accountant for $80,000 but must pay $100,000 for a male that is equally productive, then the only sensible profit-maximizing thing to do is to hire only female accountants. But, this increases the demand for female accountants and will bid up their wages. Simultaneously, the demand for male accountants would decrease, and their wages would decrease. In other words, if women are systematically underpaid, then men must be systematically overpaid. If the two are inherently equally productive, firms can always increase profits by hiring women and employing fewer men, until the wages equalize.

If irrational consumer bias reduces the productivity of women, firms would still have a profit incentive to try to persuade those consumers to work with women, perhaps by offering money-back guarantees and introductory discounts, which would be affordable if women are underpaid.

Click here to return to Question 14.24.








Answer to Question 14.25

The increase in supply will mean that more women are hired in teaching and nursing and that the wages will be lower than they otherwise would be.

Click here to return to Question 14.25.














Answer to Question 14.26

In that case, there will be a shortage of teachers and nurses as the individuals who would have been willing to work in those professions are attracted away by other professional possibilities. This decreases supply. Wages should increase when supply decreases. If wages do not adjust quickly, then there will be a shortage of teachers and nurses. But the market will go to equilibrium since the shortage will cause competition for the teachers and nurses and wages will rise.

Click here to return to Question 14.26.












Answer to Question 14.28

Recall that the marginal productivity of labor tells us how much the output will change when we hire one additional worker. Marginal revenue product (MRP) is when we multiply this by the price.  Thus, MRP is the value of the output produced by the marginal worker.  The firm will continue to hire workers as long as their MRP is greater than their wage rate.  The final worker is hired when the wage rate equals the MRP.  This is the last worker hired, as firms have already hired all profitable workers.

Click here to return to Question 14.28.








Answer to Question 14.30

On the margin, as we consider going from four to five workers, the additional quantity the fifth worker will produce is two (which is the marginal product of labor). At a price of $500, this means the marginal revenue product of labor is $1,000. The cost of hiring the additional worker is $1,000. This is the point where wage is equal to the marginal revenue created by the employee.

Click here to return to Question 14.30.













Answer to Question 14.32

The 4th worker costs the firm $500 and creates marginal revenue of $900 ($100 per unit and the worker had a marginal product of 9 units).

Since the value created by the worker is greater than cost of the labor, we look at hiring an additional worker to see if it is profitable. The additional worker would create a marginal revenue of $500 with a cost of $500. This is the point where the wage is equal to the marginal revenue product of labor. The firm would hire the 5th worker.

Click here to return to Question 14.32.












Answer to Question 14.33

If a union can successfully restrict the supply of labor in an industry, this causes the supply of labor to decrease. When this occurs, it causes the wage in the industry to rise in response. Some of the workers who want jobs in the unionized market will be unable to get jobs and will search for work in similar industries . The supply of workers in those non-unionized industries will increase, and the result will be downward pressure on the non-unionized wages. In other words, when the supply increases, wages decrease. We, therefore, see two effects from the union: increased wages in the unionized labor market and decreased wages in the non-unionized labor market.

Click here to return to Question 14.33.











Answer to Question 14.34

A high marginal revenue product of the winners does explain much of the difference. Fifty years ago, only those attending the game saw a baseball star. But now, that game is shown to millions on television.

Click here to return to Question 14.34.













Data Sources

Figure 14.2

Figure 14.3

Figure 14.4

Figure 14.8

Figure 14.11

Table 14.1: 

Image Credits

[1] Image courtesy of Gaha in the Public Domain.

[2] Image courtesy of the Environmental Protection Agency in the Public Domain.

The nominal wage adjusted for the effects of inflation.
Demand that is derived from the demand for something else. The demands for inputs into the production process are derived from the demand for the goods and services that they produce.
As we hire an additional worker, the additional output created by the worker increases total output, but is smaller and smaller for each additional worker.
The increase in revenue resulting from the hiring of one additional worker.
For each additional worker, look at how much their wages are and how much additional revenue the worker creates.
What will a firm do if the marginal revenue product is less than the wage it is paying its workers? How will the firm know when to stop doing this?
The factors such as experience, skills, education, and work habits that affect the value of a worker's marginal product.
If the labor supply in your class is typical, few, if any students would work for $5 an hour or less. Some students who currently do not work would likely offer their services at $20, maybe even $15 per hour. Most would be willing to work for $50 per hour.
Draw a graph with demand for a product decreasing. See how the new equilibrium affects the labor market. Second hint: consider whether the marginal revenue product is changed when the demand for a product decreases.
Consider how the marginal revenue would change.
Consider how the marginal revenue would change.
How will the supply curves in each of these markets vary?
A difference in the wages of jobs with similar skill requirements when the cause is that something about the position makes it less attractive than alternative positions.
Consider the labor supply curve and how it looks in each market.
Consider the labor supply curve.
Think about the marginal product of labor. Does it differ with discrimination?
How would this policy affect supply?
How would this policy affect supply?
A group of workers who have organized in an effort to increase wages and improve working conditions.
Look at the answer and think about what the marginal revenue product is.
Think on the margin.
Think on the margin. Analyze the problem by moving from 4 to 5 employees.
Consider what happens in the unionized industry and compare that to the subsequent event in the nonunion industry.
Top performers earn high income, while others, who may be almost as good, earn significantly less.
Consider the marginal product of labor and costs.