Modelling the labour market

1. Modelling the labour market Labour supply decisions The effect of a minimum wage

2. Modelling the labour market • There is one type of “commodity” that hasn’t been analysed yet • Labour !! • Although it can be analysed using the same tools as other markets, the labour market has some particularities • In terms of the properties of this “commodity”: welfare aspects are important. • In terms of asymmetric information: it is not a homogenous good, markets are “segmented”. • Therefore, it is important in terms of policy

3. Modelling the labour market The labour supply decision The classical labour market Efficiency wages Monopsony power and the minimum wage

4. The labour supply decision • Framework similar to the approach used for consumer choice and producer decisions • Labour is treated like a regular commodity • Based on an agent deriving utility from consumption and leisure • Indifference curve based on preference for consumption (which requires income) and leisure (free time) • Budget constraint based on working (which uses up free time but provides and income)

5. The labour supply decision • The labour supply decision indifference curve • Is strictly convex and decreasing • Corresponds to an utility function U(C,Λ) defined over consumption (of an aggregate basket) and leisure • Leisure brings utility ⇔ labour brings disutility Consumption(C) Leisure (Λ)

6. The labour supply decision • The labour supply decision budget constraint • First of all: Workers can earn an income independently of supplying labour (unearned income). • Labour generates a disutility, but this is compensated by a wage. Cost of consumption Labour supplied (defined as leisure not taken) Unearned income

7. The labour supply decision The labour supply decision budget constraint Consumption(C) Maximum consumption strategy B Iu Maximum leisure strategy A Leisure (Λ) Λmax

8. The labour supply decision The labour supply decision Consumption(C) The optimal point is given by the tangency between the budget constraint and the indifference curve A Labour Leisure Leisure (Λ) Λmax

9. The labour supply decision Effect of an increase in unearned income Consumption(C) An increase in unearned income increases consumption and leisure (reduces labour supply) B A Leisure (Λ) Λmax

10. The labour supply decision Effect of an increase in the wage rate An increase in the wage rate usually increases consumption and reduces leisure BUT this depends on the income/substitution effects !! An increase can reduce labour supply Consumption(C) B A Leisure (Λ) Λmax

11. Modelling the labour market The labour supply decision The classical labour market Efficiency wages Monopsony power and the minimum wage

12. The classical labour market • The supply of labour is given by the decision process shown above • Aggregated as for other commodities • The demand for labour is known as a derived demand • It comes from the cost minimisation decision of the firms, and is derived from the optimal level of output • Remember that

13. The classical labour market • Simplification : Labour is the only input • becomes • Maximisation w.r.t labour gives: • On a classical market, the firm is a price taker on all markets (including labour) Marginal revenue product of labour wage

14. The classical labour market Equilibrium on a classical market w Labour Supply w* Labour Demand (mRPL) L* L

15. The classical labour market Minimum wage on a classical market w Labour Supply Unemployment wmin Deadweight loss w* Labour Demand (mRPL) Ld Ls L* L

16. Modelling the labour market The labour supply decision The classical labour market Efficiency wages Monopsony power and the minimum wage

17. Efficiency wages • Like other markets, the labour market is far from competitive. • It is in fact one of the most “imperfect” markets • Large number of agents (not for all types of labour) • Differentiated “product”: variation in skill /ability • Entry / exit is costly/complicated on both sides • Imperfect information on skill/ability • Imperfect mobility of inputs • Has given birth to “labour economics”

18. Efficiency wages • An example of such developments is the theory of efficiency wages • The theory of efficiency wages attempts to explain why: • Some wages can be higher than the market equilibrium • There is an equilibrium unemployment • I.e. the “minimum wage diagram” seen above occurs spontaneously on some segments of the labour market

19. Efficiency wages • This theory integrates the imperfect information principal/agent theory seen in week 12 into the labour market. • The producer has limited information on the skills /abilities of the agents. • The producer’s ability to monitor the agent is limited. • The agent clearly has an incentive to “shirk”, i.e. produce below his ability. • In such a situation, the producer can raise wages above the market level and increase efficiency of production at the same time !!

20. Efficiency wages • Why would wages above market equilibrium benefit the producer ? • “Worker health” argument (only really valid for low wages): a higher wage increases the ability to work • Motivation argument: workers feel rewarded, and more motivated. • Opportunity cost argument (important): workers will not want to lose the job, and hence shirk less. • Smaller turnover ⇒ lower cost of replacing workers • Signal to market argument: Paying higher wages allows the producer to attract the more productive workers

21. Modelling the labour market The labour supply decision The classical labour market Efficiency wages Monopsony power and the minimum wage

22. Monopsony power and the minimum wage • On a classical market a minimum wage causes unemployment • This is a typical argument in the media against minimum wages • This argument depends on the existence of a competitive market for labour • But is the labour market competitive ? • There are much less demanders (firms) than suppliers)... • This raises the possibility of Monopsony power mentioned in week 8.

23. Monopsony power and the minimum wage • Just like a price ceiling can be used to reduce monopoly power, a price floor (minimum wage) can reduce Monopsony power • The following assumes a single firm employing all the workforce • This is a simplification • However, it illustrates the potential positive effect of a minimum wage in this case

24. Monopsony power and the minimum wage Monopsony equilibrium Wages Labour Supply mCL 1st : mCL=mRPL gives L 1st 2nd : given L, the supply curve gives w mPL w 2nd Marginal Revenue Product of Labour L Labour

25. Monopsony power and the minimum wage • Important property of this unemployment • Compared to efficiency wages, here the wage is belowthe equilibrium level ! • This corresponds to a “worker exploitation” idea • As a result, it is relatively easy to differentiate the two models. • Also corresponds to different types of labour: skill-intensive or “homogeneous” • This applies to different labour markets

26. Monopsony power and the minimum wage Minimum wage Wages Labour Supply mCL Wmin >w gives a constant mCL For mCL = MRPL, L increases wmin w Marginal Revenue Product of Labour L Lmin Labour

27. Monopsony power and the minimum wage Optimal Minimum wage Wages Labour Supply mCL Workers are paid at the MPL No remaining unemployment Problem: this optimal point is difficult to find w*min w Marginal Revenue Product of Labour L L*min Labour

28. Monopsony power and the minimum wage “Overdoing” the minimum wage Wages Labour Supply mCL Setting wmin > w*min creates unemployment This is because the market power is over-compensated: classical unemployment wmin w Marginal Product of Labour L Lmin Labour