Leadership Q&A (co-sponsored with the Economic Roundtable)

1. Leadership Q&A(co-sponsored with the Economic Roundtable) Tuesday September 29, 2009 4:00pm McDonough Balcony Topic: Is There A Way Out? The Role of Real Estate Dr. Peter Linneman Professor of Real Estate, Finance, and Public Policy The Wharton Business School University of Pennsylvania

2. Labor Demand (and then the Labor Market)

3. Variable input Fixed input Labor Demand • Production Function Q = f( L, K ) Q = output L = labor K = capital f(·) represents technology • Average Product AP = Q/L • Marginal Product MP = ΔQ/ ΔL Note: Diminishing Marginal Returns (DMR) When there is at least one fixed input, eventually a point is reached at which the marginal product of an additional worker begins to fall.

4. Productivity Graphs DMR output Slope = MPL = ∆Q/ ∆L Q/L ∆Q TP ∆L AP labor L1 L2 labor L1 L2 MP

5. Hiring Decision: Competitive Firm • Objective: profit maximization  = TR - TC  = PQ - wL – rK Competitive firms are price takers $ ∆TR/ ∆L = P*(∆Q/ ∆L) = P*MP = MRP w1 ∆TC/ ∆L = w w2 Hiring Rule: hire until VMP = w MRP = VMP = D Labor L1 L2

6. Hiring Decision:Imperfectly Comp. Firm Maximize  = P(Q)*Q - wL – rK ∆TR/ ∆L = MR(∆Q/ ∆L) = MR*MP = MRP $ ∆TC/ ∆L = w Hiring Rule: hire until MRP = w w1 VMP MRP L2 L1 Labor Imperfectly competitive firm hires fewer workers

7. Long Run Demand • All inputs are variable: Q = f(L, K) • A change in wages has two effects: • Output effect: • Substitution effect: w ↓MC ↓Q ↑L↑ w ↓ (w/ r) ↓L ↑ $ w1 w2 DLR DSR L1 L2 L3 Labor OE SE

8. Elasticity of Demand Measures price sensitivity of employers Example: Classification: Elastic: |E| > 1 Inelastic: |E| < 1 • Determinants • Elasticity of product demand • Ratio of labor costs to total costs • Input substitutability • Supply elasticity of other inputs

9. Elasticity of Demand • Wage Bill = w x L • Elastic: if w↑ then wage bill ↓ • Inelastic: if w↑ then wage bill ↑ $ E = - 1.32 $100 $80 D1 Labor 30 40 • Empirical estimates • E ≈ - 1.0 overall long-run elasticity in US [Hammermesh (1993)] • Higher for teens compared to adults • Higher for low-skilled workers compared to high-skilled workers • Higher in non-durable goods industries compared to durable goods

10. Elasticity of Demand • Applications • Labor unions. • Unions can achieve greater wage gains when the labor demand curve is more inelastic • Minimum wage • The employment decline of a hike in the minimum wage will be larger when the labor demand curve for affected worker is more elastic

11. Labor Demand Shifters • Product demand • Productivity • Number of employers • Prices of other inputs • Gross substitutes • Gross complements $ $100 D2 D1 Labor 30 50 Change in demand = shift in entire curve Change in quantity demanded = movement along given curve

12. Employment in the textile and apparel industries has fallen by over 50% since early 1970s. • Demand for American textile and apparel workers has fallen because the share of sales due to imports has risen from 5% in 1970 to 40% now. • Robots and assembly-line labor are gross substitutes. The price of robots has fallen and so labor demand has fallen.

13. Equilibrium at w*: Ld = Ls Disequilibrium at w1: Ld > Ls at w2: Ld < Ls Competitive Labor Market Model $ S1 w2 w* w1 D1 Ld Ls L* Ls Ld Labor Shortage Surplus Problem Set 2: #2

14. Allocative Efficiency • Labor is allocated efficiently across multiple markets when: VMP1 = VMP2 = VMPn $ S1 $ S2 w1 “Law of one price” w* w2 D1 D2 Labor Labor L1 L*1 L*2 L2 Value of market output gained Value of market output loss VMP1 > VMP2 allocate more labor to Market 1

15. Monopsony Labor Market Model Problem Set 2: #14 • Single buyer of labor • Non-discriminating employer: must pay all workers the same wage MWC Hiring Rule: hire until MRP = MWC and set wage off of S curve $ S1 DWL Note: workers are exploited in the sense that their w < MRP. wM Possible examples: > Hospitals > Schools > MLB (pre-free agency) D1 LM LC Labor

17. Cobweb Model • Boom-bust cycle due to delayed supply responses $ S1 Initial equilibrium: w1, L1 w2 Demand increases to D2: w1 D2 D1 L1 L2 Labor Stability of convergence depends on the relative elasticities.

18. Alternative Pay Schemes

20. Why might individuals be willing to trade cash for fringes? Fringes are tax free Fringes prevent people from short-term gratification at expense of long-term benefits Economics of Fringe Benefits wages Isoprofit curve: all combinations of fringes and wages that yield the same profit w* I1 F* Fringes

21. wages • Growth of fringes • Tax advantage • Economies of scale • Broad insurance coverage lowers ATC • Efficiency concerns • Lower turnover costs • Mandated benefits • SS; UI • Unions w1 w2 I2 I1 F1 F2 Fringes Isoprofit showing lower “price” of fringes

22. Principal-Agent Problem • Occurs when agents (workers) pursue objectives that conflict with goals of principals (firms) • Firms: maximize profits • Workers: maximize utility • Compensation Schemes • Pay for Performance • Efficiency Wage Payments • Deferred Pay Schemes Concern over shirking by workers

23. Pay for Performance • Piece Rates • Pay depends on number of units produced • Found where workers can control pace of work and it is easy to monitor worker effort • Income is more variable over time • Commission • Pay depends on dollar volume of sales • Found where work hours are difficult to monitor • Time-based Pay • Hourly pay • Incentive to stretch hours • Annual salary • Incentive to shirk hours • Solution: raises and promotions Typists Fruit pickers Lawyers Doctors Realtors Insurance agents Stockbrokers Sales people Musicians

24. Pay for Performance • Bonuses • Payments made beyond annual salary based on individual or team performance • “brown-nosing” problem • Free-rider problem • Profit-sharing • Payments tied to firm’s profit • Free-rider problem • Tournament pay • Pay based on relative rank-order performance • Found where it’s difficult to measure absolute effort Golf Tennis Corporate execs

25. 2004 Masters Tournament

26. Forbes Top 25 CEOs by 2005 Compensation

27. Efficiency Wages • Firms may reduce shirking by monitoring efforts of workers • Monitoring workers is costly • One solution: pay above market wages Baby sitters Security guards managers MRP  w or w  MRP $ S1 unemployment w2 w1 Higher wage may: > Increase worker effort > Increase worker capabilities • > Increase proportion of skilled • workers in LF D2 D1 L1 L2 Labor

28. Deferred Compensation • Reduces P-A problem by altering timing of pay • Prospect of higher pay at end of career may discourage shirking/turnover earlier in career • Pensions may be used to induce optimal retirement age • More likely to see deferred comp in large firms $ wage MRP Seniority pay as “implicit contract” R years