Other things equal the monopsonistic employer will pay a

10: Wage Determination IN THIS CHAPTER YOU WILL LEARN:

1 Why the firm's marginal revenue product curve is its labor demand curve.

2 The factors that increase or decrease labor demand.

3 The determinants of elasticity of labor demand.

4 How wage rates are determined in competitive and monopsonistic labor markets.

5 How unions increase wage rates.

6 The major causes of wage differentials.

We now turn from the pricing and production of goods and services to the pricing and employment of resources. Although firms come in various sizes and operate under highly different market conditions, each has a demand for productive resources. They obtain those resources from households—the direct or indirect owners of land, labor, capital, and entrepreneurial resources. So, referring to the circular flow diagram (Figure 2.2, page 43), we shift our attention from the bottom loop (where businesses supply products that households demand) to the top loop (where businesses demand resources that households supply).

A Focus on Labor The basic principles we develop in this chapter apply to land, labor, and capital resources, but we will emphasize the pricing and employment of labor. About 70 percent of all income in the United States flows to households in the form of wages and salaries. More than 146 million of us go to work each day in the United States. We have an amazing variety of jobs with thousands of different employers and receive large differences in

pay. What determines our hourly wage or annual salary? Why is the salary of, say, a topflight major-league baseball player $15 million or more a year, whereas the pay for a first-rate schoolteacher is $50,000? Why are starting salaries for college graduates who major in engineering and accounting so much higher than those for graduates majoring in journalism and sociology?

Demand and supply analysis helps us answer these questions. We begin by examining labor demand and labor supply in a purely competitive labor market. In such a market,

purely competitive labor market

A labor market in which a large number of similarly qualified workers independently offer their labor services to a large number of employers, none of whom can set the wage rate.

• Numerous employers compete with one another in hiring a specific type of labor.

• Each of many workers with identical skills supplies that type of labor.

• Individual employers and individual workers are “wage takers” because neither can control the market wage rate.

Labor Demand

WORKED PROBLEMS

W 10.1

Labor demand

Labor demand is the starting point for any discussion of wages and salaries. Other things equal, the demand for labor is an inverse relationship between the price of labor (hourly wage) and the quantity of labor demanded. As with all resources, labor demand is a derived demand: It results from the

products that labor helps produce. Labor resources usually do not directly satisfy customer wants but do so indirectly through their use in producing goods and services. Almost nobody wants to consume directly the labor services of a software engineer, but millions of people do want to use the software that the engineer helps create.

derived demand

The demand for a resource that results from the demand for the products it helps produce.

Marginal Revenue Product Because resource demand is derived from product demand, the strength of the demand will depend on the productivity of the labor—its ability to produce goods and services—and the price of the good or service it helps produce. A resource that is highly productive in turning out a highly valued commodity will be in great demand. In contrast, a relatively unproductive resource that is capable of producing only a minimally valued commodity will be in little demand. And no demand whatsoever will exist for a resource that is phenomenally efficient in producing something that no one wants to buy.

Consider the table in Figure 10.1, which shows the roles of marginal productivity and product price in determining labor demand. FIGURE 10.1: The purely competitive seller's demand for labor.

The MRP-of-labor curve is the labor demand curve; each of its points relates a particular wage rate (= MRP when profit is maximized) with a corresponding quantity of labor demanded. The downward slope of the D = MRP curve results from the law of diminishing marginal returns.

Productivity Columns 1 and 2 give the number of units of labor employed and the resulting total product (output). Column 3 provides the marginal product (MP), or additional output, resulting from using each additional unit of

labor. Columns 1 through 3 remind us that the law of diminishing returns applies here, causing the marginal product of labor to fall beyond some point. For simplicity, we assume that these diminishing marginal returns—these declines in marginal product—begin with the second worker hired.

Product Price The derived demand for labor depends also on the market value (product price) of the good or service. Column 4 in the table in Figure 10.1 adds this price information to the mix. Because we are assuming a competitive product market, product price equals marginal revenue. The firm is a price taker and will sell units of output only at this market price. And this price will also be the firm's marginal revenue. In this case, both price and marginal revenue are a constant $2.

Multiplying column 2 by column 4 provides the total-revenue data of column 5. These are the amounts of revenue the firm realizes from the various levels of employment. From these total-revenue data we can compute the marginal revenue product (MRP) of labor—the change in total revenue resulting from the use of each additional unit of labor. In equation form,

marginal revenue product (MRP)

The change in a firm's total revenue when it employs 1 more unit of labor.

The MRPs are listed in column 6 in the table.

Rule for Employing Labor: MRP = MRC The MRP schedule, shown as columns 1 and 6, is the firm's demand

schedule for labor. To understand why, you must first know the rule that guides a profit-seeking firm in hiring any resource: To maximize profit, a firm should hire additional units of labor as long as each successive unit adds more to the firm's total revenue than to the firm's total cost.

Economists use special terms to designate what each additional unit of labor (or any other variable resource) adds to total revenue and what it adds to total cost. We have seen that MRP measures how much each successive unit of labor adds to total revenue. The amount that each additional unit of labor adds to the firm's total cost is called its marginal resource cost (MRC). In equation form,

marginal resource cost (MRC)

The change in a firm's total cost when it employs 1 more unit of labor.

So we can restate our rule for hiring resources as follows: It will be profitable for a firm to hire additional units of labor up to the point at which labor's MRP is equal to its MRC. If the number of workers a firm is currently hiring is such that the MRP of the last worker exceeds his or her MRC, the firm can profit by hiring more workers. But if the number being hired is such that the MRC of the last worker exceeds his or her MRP, the firm is hiring workers who are not “paying their way” and it can increase its profit by discharging some workers. You may have recognized that this MRP = MRC rule is similar to the MR = MC profit-maximizing rule employed throughout our discussion of price and output determination. The rationale of the two rules is the same, but the point of reference is now inputs of a resource, not outputs of a product.

MRP = MRC rule

The principle that to maximize profit a firm should expand employment until the marginal revenue product (MRP) of labor equals the marginal

resource cost (MRC) of labor.

MRP as Labor Demand Schedule In a competitive labor market, market supply and market demand establish the wage rate. Because each firm hires such a small fraction of the market supply of labor, an individual firm cannot influence the market wage rate; it is a wage taker, not a wage maker. This means that for each additional unit of labor hired, total labor cost increases by exactly the amount of the constant market wage rate. The MRC of labor exactly equals the market wage rate. Thus, resource “price” (the market wage rate) and resource “cost” (marginal resource cost) are equal for a firm that hires labor in a competitive labor market. Then the MRP = MRC rule tells us that a competitive firm will hire units of labor up to the point at which the market wage rate (its MRC) is equal to its MRP.

In terms of the data in columns 1 and 6 of Figure 10.1 's table, if the market wage rate is, say, $13.95, the firm will hire only one worker. This is the outcome because the first worker adds $14 to total revenue and slightly less—$13.95—to total cost. In other words, because MRP exceeds MRC for the first worker, it is profitable to hire that worker. For each successive worker, however, MRC (= $13.95) exceeds MRP (= $12 or less), indicating that it will not be profitable to hire any of those workers. If the wage rate is $11.95, by the same reasoning we discover that it will pay the firm to hire both the first and second workers. Similarly, if the wage rate is $9.95, three will be hired; if it is $7.95, four; if it is $5.95, five; and so forth. The MRP schedule therefore constitutes the firm's demand for labor because each point on this schedule (or curve) indicates the quantity of labor units the firm would hire at each possible wage rate. In the graph in Figure 10.1, we show the D = MRP curve based on the data in the table. The competitive firm's labor demand curve identifies an inverse relationship between the wage rate and the quantity of labor demanded, other things equal. The curve slopes downward because of

diminishing marginal returns.1

Market Demand for Labor We have now explained the individual firm's demand curve for labor. Recall that the total, or market, demand curve for a product is found by summing horizontally the demand curves of all individual buyers in the market. The market demand curve for a particular resource is derived in essentially the same way. Economists sum horizontally the individual labor demand curves of all firms hiring a particular kind of labor to obtain the market demand for that labor.

Changes in Labor Demand What will alter the demand for labor (shift the labor demand curve)? The fact that labor demand is derived from product demand and depends on resource productivity suggests two “resource demand shifters.” Also, our analysis of how changes in the prices of other products can shift a product's demand curve (Chapter 3) suggests another factor: changes in the prices of other resources.

Changes in Product Demand Other things equal, an increase in the demand for a product will increase the demand for a resource used in its production, whereas a decrease in product demand will decrease the demand for that resource.

Let's see how this works. The first thing to recall is that a change in the demand for a product will normally change its price. In the table in Figure 10.1, let's assume that an increase in product demand boosts product price from $2 to $3. You should calculate the new labor demand schedule (columns 1 and 6) that would result, and plot it in the graph to verify that the new labor demand curve lies to the right of the old demand curve. Similarly, a decline in the product demand (and price) will shift the labor

demand curve to the left. The fact that labor demand changes along with product demand demonstrates that labor demand is derived from product demand.

Example: With no offsetting change in supply, a decrease in the demand for new houses will drive down house prices. Those lower prices will decrease the MRP of construction workers, and therefore the demand for construction workers will fall. The labor demand curve will shift to the left.

Changes in Productivity Other things equal, an increase in the productivity of a resource will increase the demand for the resource and a decrease in productivity will reduce the demand for the resource. If we doubled the MP data of column 3 in the table in Figure 10.1, the MRP data of column 6 also would double, indicating a rightward shift of the labor demand curve in the graph.

The productivity of any resource may be altered over the long run in several ways:

• Quantities of other resources The marginal productivity of any resource will vary with the quantities of the other resources used with it. The greater the amount of capital and land resources used with labor, the greater will be labor's marginal productivity and, thus, labor demand.

• Technological advance Technological improvements that increase the quality of other resources, such as capital, have the same effect. The better the quality of capital, the greater the productivity of labor used with it. Dockworkers employed with a specific amount of capital in the form of unloading cranes are more productive than dockworkers with the same amount of capital embodied in older conveyor-belt systems.

• Quality of labor Improvements in the quality of labor will increase its marginal productivity and therefore its demand. In effect, there will be a new demand curve for a different, more skilled, kind of

labor.

Changes in the Prices of Other Resources Changes in the prices of other resources may change the demand for labor.

Substitute Resources Suppose that labor and capital are substitutable in a certain production process. A firm can produce some specific amount of output using a relatively small amount of labor and a relatively large amount of capital, or vice versa. What happens if the price of machinery (capital) falls? The effect on the demand for labor will be the net result of two opposed effects: the substitution effect and the output effect.

• Substitution effect The decline in the price of machinery prompts the firm to substitute machinery for labor. This allows the firm to produce its output at lower cost. So at the fixed wage rate, smaller quantities of labor are now employed. This substitution effect decreases the demand for labor. More generally, the substitution effect indicates that a firm will purchase more of an input whose relative price has declined and, conversely, use less of an input whose relative price has increased.

substitution effect

The replacement of labor by capital when the price of capital falls.

• Output effect Because the price of machinery has declined, the costs of producing various outputs also must decline. With lower costs, the firm can profitably produce and sell a greater output. The greater output increases the demand for all resources, including labor. So this output effect increases the demand for labor. More generally, the output effect means that the firm will purchase more of one particular input when the price of the other input falls and less of that particular input when the price of the other input rises.

output effect

An increase in the use of labor that occurs when a decline in the price of capital reduces a firm's production costs and therefore enables it to sell more output.

• Net effect The substitution and output effects are both present when the price of an input changes, but they work in opposite directions. For a decline in the price of capital, the substitution effect decreases the demand for labor and the output effect increases it. The net change in labor demand depends on the relative sizes of the two effects: If the substitution effect outweighs the output effect, a decrease in the price of capital decreases the demand for labor. If the output effect exceeds the substitution effect, a decrease in the price of capital increases the demand for labor.

Complementary Resources Resources may be complements rather than substitutes in the production process; an increase in the quantity of one of them also requires an increase in the amount of the other used, and vice versa. Suppose a small design firm does computer-assisted design (CAD) with relatively expensive personal computers as its basic piece of capital equipment. Each computer requires exactly one design engineer to operate it; the machine is not automated—it will not run itself—and a second engineer would have nothing to do.

Now assume that these computers substantially decline in price. There can be no substitution effect because labor and capital must be used in fixed proportions: one person for one machine. Capital cannot be substituted for labor. But there is an output effect. Other things equal, the reduction in the price of capital goods means lower production costs. It will therefore be profitable to produce a larger output. In doing so, the firm will use both more capital and more labor. When labor and capital are complementary, a decline in the price of capital increases the demand

for labor through the output effect.

We have cast our analysis of substitute resources and complementary resources mainly in terms of a decline in the price of capital. Obviously, an increase in the price of capital causes the opposite effects on labor demand. Photo Op: Substitute Resources versus Complementary Resources

© Photodisc/Getty Images

© Royalty-Free/CORBIS

Automatic teller machines (ATMs) and human tellers are substitute resources, whereas construction equipment and their operators are complementary resources.

APPLYING THE ANALYSIS: Occupational Employment Trends Changes in labor demand are of considerable significance because they affect employment in specific occupations. Other things equal, increases in labor demand for certain occupational groups result in increases in their employment; decreases in labor demand result in decreases in their employment. For illustration, let's look at occupations that are growing and declining in demand.

Table 10.1 lists the 10 fastest-growing and 10 most rapidly declining U.S. occupations (in percentage terms) for 2006 to 2016, as projected by the Bureau of Labor Statistics. Notice that service occupations

dominate the fastest-growing list. In general, the demand for service workers is rapidly outpacing the demand for manufacturing, construction, and mining workers in the United States. TABLE 10.1: The 10 Fastest-Growing and Most Rapidly Declining U.S. Occupations, in Percentage Terms, 2006–2016

Of the 10 fastest-growing occupations in percentage terms, three— personal and home care aides (people who provide home care for the elderly and those with disabilities), home health care aides (people who provide short-term medical care after discharge from hospitals), and medical assistants—are related to health care. The rising demands for these types of labor are derived from the growing demand for health services, caused by several factors. The aging of the U.S. population has brought with it more medical problems, rising incomes have led to greater expenditures on health care, and the growing presence of private and public insurance has allowed people to buy more health care than most could afford individually.

Two of the fastest-growing occupations are directly related to computers. The increase in the demand for network systems and data communication analysts and for computer software engineers arises from the rapid rise in the demand for computers, computer services, and the Internet. It also results from the rising marginal revenue productivity of these particular workers, given the vastly improved quality of the computer and communications equipment they work with. Moreover, price declines on such equipment have had stronger output effects than substitution effects, increasing the demand for these kinds of labor.

Table 10.1 also lists the 10 U.S. occupations with the greatest projected job loss (in percentage terms) between 2006 and 2016. These occupations are more diverse than the fastest-growing occupations. Four of the ten are related to textiles, apparel, and shoes. The U.S. demand for these goods is increasingly being fulfilled through imports, some of which is related to outsourcing those jobs to workers abroad. Declines in other occupations in the list (for example, file clerks, model and pattern makers, and telephone operators) have resulted from technological advances that have enabled firms to replace workers with automated or computerized equipment. The advent of digital photography explains the projected decline in the employment of people operating photographic processing equipment.

Question:

Name some occupation (other than those listed) that you think will grow in demand over the next decade. Name an occupation that you think will decline in demand. In each case, explain your reasoning.

Elasticity of Labor Demand The employment changes we have just discussed have resulted from shifts in the locations of labor demand curves. Such changes in demand must be distinguished from changes in the quantity of labor demanded caused by a change in the wage rate. Such a change is caused not by a shift of the demand curve but, rather, by a movement from one point to another on a fixed labor demand curve. Example: In Figure 10.1 we note that an increase in the wage rate from $5 to $7 will reduce the quantity of labor demanded from 5 units to 4 units. This is a change in the quantity of labor demanded as distinct from a change in labor demand.

The sensitivity of labor quantity to changes in wage rates is measured by the elasticity of labor demand (or wage elasticity of demand). In coefficient form,

elasticity of labor demand

A measure of the responsiveness of labor quantity to a change in the wage rate.

ORIGIN OF THE IDEA

O 10.1

Elasticity of resource demand

When Ew is greater than 1, labor demand is elastic; when Ew is less than 1,

labor demand is inelastic; and when Ew equals 1, labor demand is unit-

elastic. Several factors interact to determine the wage elasticity of demand.

Ease of Resource Substitutability The greater the substitutability of other resources for labor, the more elastic is the demand for labor. Example: Because automated voice-mail systems are highly substitutable for telephone receptionists, the demand for receptionists is quite elastic. In contrast, there are few good substitutes for physicians, so demand for them is less elastic or even inelastic.

Time can play a role in the input substitution process. For example, a firm's truck drivers may obtain a substantial wage increase with little or no immediate decline in employment. But over time, as the firm's trucks wear out and are replaced, that wage increase may motivate the company to purchase larger trucks and in that way deliver the same total output with fewer drivers.

Elasticity of Product Demand The greater the elasticity of product demand, the greater is the elasticity of labor demand. The derived nature of resource demand leads us to expect this relationship. A small rise in the price of a product (caused by a wage increase) will sharply reduce output if product demand is elastic. So a relatively large decline in the amount of labor demanded will result. This means that the demand for labor is elastic.

Ratio of Labor Cost to Total Cost The larger the proportion of total production costs accounted for by labor, the greater is the elasticity of demand for labor. In the extreme, if labor

cost is the only production cost, then a 20 percent increase in wage rates will increase marginal cost and average total cost by 20 percent. If product demand is elastic, this substantial increase in costs will cause a relatively large decline in sales and a sharp decline in the amount of labor demanded. So labor demand is highly elastic. But if labor cost is only 50 percent of production cost, then a 20 percent increase in wage rates will increase costs by only 10 percent. With the same elasticity of product demand, this will cause a relatively small decline in sales and therefore in the amount of labor demanded. In this case the demand for labor is much less elastic.

Market Supply of Labor Let's now turn to the supply side of a purely competitive labor market. The supply curve for each type of labor slopes upward, indicating that employers as a group must pay higher wage rates to obtain more workers. Employers must do this to bid workers away from other industries, occupations, and localities. Within limits, workers have alternative job opportunities. For example, they may work in other industries in the same locality, or they may work in their present occupations in different cities or states, or they may work in other occupations.

Firms that want to hire these workers must pay higher wage rates to attract them away from the alternative job opportunities available to them. They also must pay higher wages to induce people who are not currently in the labor force—who are perhaps doing household activities or enjoying leisure —to seek employment. In short, assuming that wages are constant in other labor markets, higher wages in a particular labor market entice more workers to offer their labor services in that market. This fact results in a direct relationship between the wage rate and the quantity of labor supplied, as represented by the upward-sloping market supply-of-labor curve S in Figure 10.2a. FIGURE 10.2: A purely competitive labor market.

In a purely competitive labor market (a) the equilibrium wage rate Wc

and the number of workers Qc are determined by labor supply S and

labor demand D. Because this market wage rate is given to the individual firm (b) hiring in this market, its labor supply curve s = MRC is perfectly elastic. Its labor demand curve, d, is its MRP curve (here labeled mrp). The firm maximizes its profit by hiring workers up to the point where MRP = MRC.

Wage and Employment Determination What determines the market wage rate and how do firms respond to it? Suppose 200 firms demand a particular type of labor, say, carpenters. These firms need not be in the same industry; industries are defined according to the products they produce and not the resources they employ. Thus, firms producing wood-framed furniture, wood windows and doors, houses and apartment buildings, and wood cabinets will demand carpenters. To find the total, or market, labor demand curve for a particular labor service, we sum horizontally the labor demand curves (the marginal revenue product curves) of the individual firms, as indicated in Figure 10.2. The horizontal summing of the 200 labor demand curves like d in Figure 10.2b yields the

market labor demand curve D in Figure 10.2a.

The intersection of the market labor demand curve D and the market labor supply curve S in Figure 10.2 a determines the equilibrium wage rate and the level of employment in this purely competitive labor market. Observe that the equilibrium wage rate is Wc ($10) and the number of workers hired

is Qc (1000).

To the individual firm (Figure 10.2b) the market wage rate Wc is given at

$10. Each of the many firms employs such a small fraction of the total available supply of this type of labor that no single firm can influence the wage rate. As shown by the horizontal line s in Figure 10.2b, the supply of labor faced by an individual firm is perfectly elastic. It can hire as many or as few workers as it wants to at the market wage rate. This fact is clarified in Table 10.2, where we see that the marginal cost of labor MRC is constant at $10 and is equal to the wage rate. Each additional unit of labor employed adds precisely its own wage rate (here, $10) to the firm's total resource cost.

TABLE 10.2: The Supply of Labor: Pure Competition in the Hire of Labor

INTERACTIVE GRAPHS

G 10.1

Competitive labor market

Each individual firm will apply the MRP = MRC rule to determine its profitmaximizing level of employment. So the competitive firm maximizes its profit by hiring units of labor to the point at which its wage rate (= MRC) equals MRP. In Figure 10.2b the employer will hire qc (5) units of

labor, paying each worker the market wage rate Wc ($10). The other 199

firms (not shown) in this labor market will also each employ 5 workers and pay $10 per hour. The workers will receive pay based on their contribution to the firm's output and thus revenues.

Monopsony In the purely competitive labor market, each firm can hire as little or as much labor as it needs at the market wage rate, as reflected in its horizontal labor supply curve. The situation is strikingly different in monopsony, a market in which a single employer of labor has substantial buying (hiring) power. Labor market monopsony has the following characteristics:

• There is only a single buyer of a particular type of labor.

• This type of labor is relatively immobile, either geographically or because workers would have to acquire new skills.

• The firm is a “wage maker,” because the wage rate it must pay varies directly with the number of workers it employs.

monopsony

A market structure in which only a single buyer of a good, service, or

resource is present.

ORIGIN OF THE IDEA

O 10.2

Monopsony

As is true of monopoly power, there are various degrees of monopsony power. In pure monopsony such power is at its maximum because only a single employer hires labor in the labor market. The best real-world examples are probably the labor markets in towns that depend almost entirely on one major firm. For example, a silvermining company may be almost the only source of employment in a remote Idaho town. A Wisconsin paper mill, a Colorado ski resort, or an Iowa food processor may provide most of the employment in its locale. In other cases, three or four firms may each hire a large portion of the supply of labor in a certain market and therefore have some monopsony power. Moreover, if they illegally act in concert in hiring labor, they greatly enhance their monopsony power.

Upward-Sloping Labor Supply to Firm When a firm hires most of the available supply of a certain type of labor, its decision to employ more or fewer workers affects the wage rate it pays to those workers. Specifically, if a firm is large in relation to the size of the labor market, it will have to pay a higher wage rate to obtain more labor. Suppose that only one employer hires a particular type of labor in a certain geographic area. In this pure monopsony situation, the labor supply curve for the firm and the total labor supply curve for the labor market are identical. The monopsonist's supply curve—represented by curve S in Figure 10.3—is upsloping because the firm must pay higher wage rates if it wants to attract and hire additional workers. This same curve is also the monopsonist's average-cost-of-labor curve. Each point on curve S indicates the wage rate (cost) per worker that must be paid to attract the corresponding number of workers.

FIGURE 10.3: Monopsony.

In a monopsonistic labor market the employer's marginal resource (labor) cost curve (MRC) lies above the labor supply curve S. Equating MRC with MRP at point b, the monopsonist hires Qm workers

(compared with Qc under competition). As indicated by point c on S, it

pays only wage rate Wm (compared with the competitive wage Wc).

MRC Higher Than the Wage Rate When a monopsonist pays a higher wage to attract an additional worker, it must pay that higher wage not only to the additional worker, but to all the workers it is currently employing at a lower wage. If not, labor morale will deteriorate, and the employer will be plagued with labor unrest because of wage-rate differences existing for the same job. Paying a uniform wage to all workers means that the cost of an extra worker—the marginal resource (labor) cost (MRC)—is the sum of that worker's wage

rate and the amount necessary to bring the wage rate of all current workers up to the new wage level.

WORKED PROBLEMS

W 10.2

Labor markets: competition and monopsony

Table 10.3 illustrates this point. One worker can be hired at a wage rate of $6. But hiring a second worker forces the firm to pay a higher wage rate of $7. The marginal resource cost of the second worker is $8—the $7 paid to the second worker plus a $1 raise for the first worker. From another viewpoint, total labor cost is now $14 (= 2 × $7), up from $6. So the MRC of the second worker is $8 (= $14 − $6), not just the $7 wage rate paid to that worker. Similarly, the marginal labor cost of the third worker is $10—the $8 that must be paid to attract this worker from alternative employment plus $1 raises, from $7 to $8, for the first two workers.

TABLE 10.3: The Supply of Labor: Monopsony in the Hiring of Labor

Here is the key point: Because the monopsonist is the only employer in the labor market, its marginal resource (labor) cost exceeds the wage rate. Graphically, the monopsonist's MRC curve lies above the average-cost-of- labor curve, or labor supply curve S, as is clearly shown in Figure 10.3.

Equilibrium Wage and Employment How many units of labor will the monopsonist hire, and what wage rate will it pay? To maximize profit, the monopsonist will employ the quantity of labor Qm in Figure 10.3 because at that quantity MRC and MRP are

equal (point b). The monopsonist next determines how much it must pay to attract these Qm workers. From the supply curve S, specifically point c,

it sees that it must pay wage rate Wm. Clearly, it need not pay a wage

equal to MRP; it can attract and hire exactly the number of workers it wants (Qm)

with wage rate Wm. And that is the wage that it will pay.

INTERACTIVE GRAPHS

G 10.2

Monopsony

Contrast these results with those that would prevail in a competitive labor market. With competition in the hiring of labor, the level of employment would be greater (at Qc) and the wage rate would be higher (at Wc).

Other things equal, the monopsonist maximizes its profit by hiring a smaller number of workers and thereby paying a less-than-competitive wage rate. Society obtains a smaller output, and workers get a wage rate that is less by bc than their marginal revenue product.

APPLYING THE ANALYSIS: Monopsony

Power Fortunately, monopsonistic labor markets are uncommon in the United States. In most labor markets, several potential employers compete for most workers, particularly for workers who are occupationally and geographically mobile. Also, where monopsony labor market outcomes might have otherwise occurred, unions have sprung up to counteract that power by forcing firms to negotiate wages. Nevertheless, economists have found some evidence of monopsony power in such diverse labor markets as the markets for nurses, professional athletes, public school teachers, newspaper employees, and some building-trade workers.

In the case of nurses, the major employers in most locales are a relatively small number of hospitals. Further, the highly specialized skills of nurses are not readily transferable to other occupations. It has been found, in accordance with the monopsony model, that, other things equal, the smaller the number of hospitals in a town or city (that is, the greater the degree of monopsony), the lower the beginning salaries of nurses.

Professional sports leagues also provide a good example of monopsony, particularly as it relates to the pay of first-year players. The National Football League, the National Basketball Association, and Major League Baseball assign first-year players to teams through “player drafts.” That device prohibits other teams from competing for a player's services, at least for several years, until the player becomes a “free agent.” In this way the league exercises monopsony power, which results in lower salaries than would occur under competitive conditions.

Question:

The salaries of star players often increase substantially when they become free agents. How does that fact relate to monopsony power?

Union Models

Our assumption thus far has been that workers compete with one another in selling their labor services. In some labor markets, however, workers unionize and sell their labor services collectively. In the United States, about 12 percent of wage and salary workers belong to unions. (As shown in Global Snapshot 10.1, this percentage is low relative to some other nations.)

Union efforts to raise wage rates are mainly concentrated on the supply side of the labor market.

GLOBAL SNAPSHOT 10.1: Union Membership Compared with most other industrialized nations, the percentage of wage and salary earners belonging to unions in the United States is small.

Source: Jelle Visser, “Union Membership in 24 Countries,” Monthly Labor Review, January 2006, 38–49. Data are for 2003.

Exclusive or Craft Union Model Unions can boost wage rates by reducing the supply of labor, and over the years organized labor has favored policies to do just that. For example, labor unions have supported legislation that has (1) restricted permanent immigration, (2) reduced child labor, (3) encouraged compulsory retirement, and (4) enforced a shorter workweek.

Moreover, certain types of workers have adopted techniques designed to restrict the number of workers who can join their union. This is especially true of craft unions, whose members possess a particular skill, such as

carpenters or brick masons or plumbers. Craft unions have frequently forced employers to agree to hire only union members, thereby gaining virtually complete control of the labor supply. Then, by following restrictive membership policies—for example, long apprenticeships, very high initiation fees, and limits on the number of new members admitted— they have artificially restricted labor supply. As indicated in Figure 10.4, such practices result in higher wage rates and constitute what is called exclusive unionism. By excluding workers from unions and therefore from the labor supply, craft unions succeed in elevating wage rates.

exclusive unionism

The union practice of restricting the supply of skilled union labor to increase the wage rate received by union members. FIGURE 10.4: Exclusive or craft unionism.

By reducing the supply of labor (say, from S1 to S2) through the use

of restrictive membership policies, exclusive unions achieve higher wage rates (Wc to Wu). However, restriction of the labor supply also

reduces the number of workers employed (Qc to Qu).

This craft union model is also applicable to many professional organizations, such as the American Medical Association, the National Education Association, the American Bar Association, and hundreds of others. Such groups seek to limit competition for their services from less- qualified labor suppliers. One way to accomplish that is through occupational licensing. Here, a group of workers in a given occupation pressure Federal, state, or municipal government to pass a law that says that some occupational group (for example, barbers, physicians, lawyers, plumbers, cosmetologists, egg graders, pest controllers) can practice their trade only if they meet certain requirements. Those requirements might include level of education, amount of work experience, and the passing of an examination. Members of the licensed occupation typically dominate the licensing board that administers such laws. The result is self- regulation, which can lead to policies that restrict entry to the occupation and reduce labor supply.

occupational licensing

Government laws that require a worker to satisfy certain specified requirements and obtain a license from a licensing board before engaging in a particular occupation.

The expressed purpose of licensing is to protect consumers from incompetent practitioners—surely a worthy goal. But such licensing, if abused, simply results in above-competitive wages and earnings for those in the licensed occupation (Figure 10.4). Moreover, licensing requirements often include a residency requirement, which inhibits the interstate movement of qualified workers. Some 600 occupations are now licensed in the United States.

Inclusive or Industrial Union Model

Instead of trying to limit their membership, however, most unions seek to organize all available workers. This is especially true of the industrial unions, such as those of the automobile workers and steelworkers. Such unions seek as members all available unskilled, semiskilled, and skilled workers in an industry. A union can afford to be exclusive when its members are skilled craftspersons for whom there are few substitutes. But for a union composed of unskilled and semiskilled workers, a policy of limited membership would make available to the employers numerous nonunion workers who are highly substitutable for the union workers.

An industrial union that includes virtually all available workers in its membership can put firms under great pressure to agree to its wage demands. Because of its legal right to strike, such a union can threaten to deprive firms of their entire labor supply. And an actual strike can do just that.

We illustrate such inclusive unionism in Figure 10.5. Initially, the competitive equilibrium wage rate is Wc and the level of employment is

Qc. Now suppose an industrial union is formed that demands a higher,

above-equilibrium wage rate of, say, Wu. That wage rate Wu would create

a perfectly elastic labor supply over the range ae in Figure 10.5. If firms wanted to hire any workers in this range, they would have to pay the union-imposed wage rate. If they decide against meeting this wage demand, the union will supply no labor at all, and the firms will be faced with a strike. If firms decide it is better to pay the higher wage rate than to suffer a strike, they will cut back on employment from Qc to Qu.

inclusive unionism

The union practice of including as members all workers employed in an industry. FIGURE 10.5: Inclusive or industrial unionism.

By organizing virtually all available workers in order to control the supply of labor, inclusive industrial unions may impose a wage rate, such as Wu, that is above the competitive wage rate Wc. In effect, this

changes the labor supply curve from S to aeS. At wage rate Wu,

employers will cut employment from Qc to Qu.

By agreeing to the union's Wu wage demand, individual employers

become wage takers at the union wage rate Wu. Because labor supply is

perfectly elastic over range ae, the marginal resource (labor) cost is equal to the union wage rate Wu over this range. The Qu level of employment is

the result of employers' equating this MRC (now equal to the union wage rate) with MRP, according to our profitmaximizing rule.

Note from point e on labor supply curve S that Qe workers desire

employment at wage Wu. But as indicated by point b on labor demand

curve D, only Qu workers are employed. The result is a surplus of labor

of Qe − Qu (also shown by distance eb). In a purely competitive labor

market without the union, the effect of a surplus of unemployed workers would be lower wages. Specifically, the wage rate would fall to the equilibrium level Wc, where the quantity of labor supplied equals the

quantity of labor demanded (each, Qc). But this drop in wages does not

happen because workers are acting collectively through their union. Individual workers cannot offer to work for less than Wu; nor can

employers pay less than that.

Wage Increases and Unemployment Evidence suggests that union members on average achieve a 15-percent wage advantage over nonunion workers. But when unions are successful in raising wages, their efforts also have another major effect. As Figures 10.4 and 10.5 suggest, the wage-raising actions achieved by both exclusive and inclusive unionism reduce employment in unionized firms. Simply put, a union's success in achieving aboveequilibrium wage rates thus tends to be accompanied by a decline in the number of workers employed. That result acts as a restraining influence on union wage demands. A union cannot expect to maintain solidarity within its ranks if it seeks a wage rate so high that joblessness will result for, say, 20 percent or 30 percent of its members.

Wage Differentials Hourly wage rates and annual salaries differ greatly among occupations. In Table 10.4 we list average annual salaries for a number of occupations to illustrate such wage differentials. For example, observe that aircraft pilots on average earn six times as much as retail salespersons. Not shown, there are also large wage differentials within some of the occupations listed. For

example, some highly experienced pilots earn several times as much income as pilots just starting their careers. And, although average wages for retail salespersons are relatively low, some top salespersons selling on commission make several times the average wages listed for their occupation.

wage differentials

The differences between the wage received by one worker or group of workers and that received by another worker or group of workers.

TABLE 10.4: Average Annual Wages in Selected Occupations, 2007

What explains wage differentials such as these? Once again, the forces of demand and supply are highly revealing. As we demonstrate in Figure 10.6,

wage differentials can arise on either the supply or the demand side of labor markets. Panels (a) and (b) in Figure 10.6 represent labor markets for two occupational groups that have identical labor supply curves. Labor market (a) has a relatively high equilibrium wage (Wa) because labor demand is

very strong. In labor market (b) the equilibrium wage is relatively low (Wb) because labor demand is weak. Clearly, the wage differential between

occupations (a) and (b) results solely from differences in the magnitude of labor demand. FIGURE 10.6: Labor demand, labor supply, and wage differentials.

The wage differential between labor markets (a) and (b) results solely from differences in labor demand. In labor markets (c) and (d), differences in labor supply are the sole cause of the wage differential.

Contrast that situation with panels (c) and (d) in Figure 10.6, where the labor demand curves are identical. In labor market (c) the equilibrium wage is relatively high (Wc) because labor supply is highly restricted. In labor

market (d) labor supply is highly abundant, so the equilibrium wage (Wd) is

relatively low. The wage differential between (c) and (d) results solely from the differences in the magnitude of labor supply.

Although Figure 10.6 provides a good starting point for understanding wage differentials, we need to know why demand and supply conditions differ in various labor markets. There are several reasons.

Marginal Revenue Productivity The strength of labor demand—how far rightward the labor demand curve is located—differs greatly among occupations due to differences in how much various occupational groups contribute to the revenue of their respective employers. This revenue contribution, in turn, depends on the workers' productivity and the strength of the demand for the products they are helping to produce. Where labor is highly productive and product demand is strong, labor demand also is strong and, other things equal, pay is high. Top professional athletes, for example, are highly productive at producing sports entertainment, for which millions of people are willing to pay billions of dollars over the course of a season. So the marginal revenue productivity of these top players is exceptionally high, as are their salaries (as represented in Figure 10.6a). In contrast, in most occupations workers generate much more modest revenue for their employers, so their pay is lower (as in Figure 10.6b).

Noncompeting Groups

On the supply side of the labor market, workers are not homogeneous; they differ in their mental and physical capacities and in their education and training. At any given time the labor force is made up of many noncompeting groups of workers, each representing several occupations for which the members of that particular group qualify. In some groups qualified workers are relatively few, whereas in others they are plentiful. And workers in one group do not qualify for the occupations of other groups.

Ability Only a few workers have the ability or physical attributes to be brain surgeons, concert violinists, top fashion models, research chemists, or professional athletes. Because the supply of these particular types of labor is very small in relation to labor demand, their wages are high (as in Figure 10.6c). The members of these and similar groups do not compete with one another or with other skilled or semiskilled workers. The violinist does not compete with the surgeon, nor does the surgeon compete with the violinist or the fashion model.

Education and Training Another source of wage differentials is differing amounts of human capital, which is the personal stock of knowledge, know-how, and skills that enables a person to be productive and thus to earn income. Such stocks result from investments in human capital. Like expenditures on machinery and equipment, productivity-enhancing expenditures on education or training are investments. In both cases, people incur present costs with the intention that those expenditures will lead to a greater flow of future earnings.

human capital

The personal stock of knowledge, know-how, and skills that enables a person to be productive and thus to earn income.

ORIGIN OF THE IDEA

O 10.3

Human capital

Figure 10.7 indicates that workers who have made greater investments in education achieve higher incomes during their careers. The reason is twofold: (1) There are fewer such workers, so their supply is limited relative to less-educated workers, and (2) more educated workers tend to be more productive and thus in greater demand. Figure 10.7 also indicates that the incomes of better-educated workers generally rise more rapidly than those of poorly educated workers. The primary reason is that employers provide more on-the-job training to the bettereducated workers, boosting their marginal revenue productivity and therefore their earnings. FIGURE 10.7: Education levels and average annual income.

Annual income by age is higher for workers with more education. Investment in education yields a return in the form of earnings differences enjoyed over one's work life.

Source: U.S. Bureau of the Census, www.census.gov. Data are for 2006 and include both men and women.

Although education yields higher incomes, it carries substantial costs. A

college education involves not only direct costs (tuition, fees, books) but indirect or opportunity costs (forgone earnings) as well. Does the higher pay received by better-educated workers compensate for these costs? The answer is yes. Rates of return are estimated to be 10 to 13 percent for investments in secondary education and 8 to 12 percent for investments in college education. One generally accepted estimate is that each year of schooling raises a worker's wage by about 8 percent. Currently, college graduates on average earn about $1.70 for each $1 earned by high school graduates.

ILLUSTRATING THE IDEA: My Entire Life For some people, high earnings have little to do with actual hours of work and much to do with their tremendous skill, which reflects their accumulated stock of human capital. The point is demonstrated in the following story: It is said that a tourist once spotted the famous Spanish artist Pablo Picasso (1881–1973) in a Paris café. The tourist asked Picasso if he would do a sketch of his wife for pay. Picasso sketched the wife in a matter of minutes and said, “That will be 10,000 francs [roughly $2000].” Hearing the high price, the tourist became irritated, saying, “But that took you only a few minutes.”

“No,” replied Picasso, “it took me my entire life!”

Question:

In general, how do the skill requirements of the highest-paying occupations in Table 10.4 compare with the skill requirements of the lowest-paying occupations?

Compensating Differences If the workers in a particular noncompeting group are equally capable of performing several different jobs, you might expect the wage rates to be identical for all these jobs. Not so. A group of high school graduates may

be equally capable of becoming sales-clerks or general construction workers, but these jobs pay different wages. In virtually all locales, construction laborers receive much higher wages than salesclerks. These wage differentials are called compensating differences because they must be paid to compensate for nonmonetary differences in various jobs.

compensating differences

Wage differentials received by workers to compensate them for nonmonetary disparities in their jobs.

The construction job involves dirty hands, a sore back, the hazard of accidents, and irregular employment, both seasonally and cyclically. The retail sales job means clean clothing, pleasant air-conditioned surroundings, and little fear of injury or layoff. Other things equal, it is easy to see why workers would rather pick up a credit card than a shovel. So the amount of labor that is supplied to construction firms (as in Figure 10.6c) is smaller than that which is supplied to retail shops (as in Figure 10.6d). Construction firms must pay higher wages than retailers to compensate for the unattractive nonmonetary aspects of construction jobs.

Compensating differences play an important role in allocating society's scarce labor resources. If very few workers want to be garbage collectors, then society must pay high wages to garbage collectors to get the garbage collected. If many more people want to be salesclerks, then society need not pay them as much as it pays garbage collectors to get those services performed.

APPLYING THE ANALYSIS: The Minimum Wage Since the passage of the Fair Labor Standards Act in 1938, the United States has had a Federal minimum wage. That wage has ranged between 35 and 50 percent of the average wage paid to manufacturing workers and was $5.85 per hour in 2007 and is scheduled to rise to $6.55 in July 2008 and $7.25 in July 2009. Numerous states, however, have minimum

wages considerably above the Federal mandate. The purpose of minimum wages is to provide a “wage floor” that will help less-skilled workers earn enough income to escape poverty.

Critics, reasoning in terms of Figure 10.5, contend that an above- equilibrium minimum wage (say, Wu) will simply cause employers to

hire fewer workers. Downsloping labor demand curves are a reality. The higher labor costs may even force some firms out of business. In either case, some of the poor, low-wage workers whom the minimum wage was designed to help will find themselves out of work. Critics point out that a worker who is unemployed and desperate to find a job at a minimum wage of $6.55 per hour is clearly worse off than he or she would be if employed at a market wage rate of, say, $6.10 per hour.

A second criticism of the minimum wage is that it is “poorly targeted” to reduce household poverty. Critics point out that much of the benefit of the minimum wage accrues to workers, including many teenagers, who do not live in impoverished households.

Advocates of the minimum wage say that critics analyze its impact in an unrealistic context, specifically a competitive labor market (Figure 10.2). But in a less-competitive, low-pay labor market where employers possess some monopsony power (Figure 10.3), the minimum wage can increase wage rates without causing significant unemployment. Indeed, a higher minimum wage may even produce more jobs by eliminating the motive that monopsonistic firms have for restricting employment. For example, a minimum-wage floor of Wc in Figure 10.3 would change the firm's

labor supply curve to WcaS and prompt the firm to increase its

employment from Qm workers to Qc workers.

Moreover, even if the labor market is competitive, the higher wage rate might prompt firms to find more productive tasks for low-paid workers, thereby raising their productivity. Alternatively, the minimum wage may reduce labor turnover (the rate at which workers voluntarily quit). With fewer low-productive trainees, the average productivity of the firm's

workers would rise. In either case, the alleged negative employment effects of the minimum wage might not occur.

Which view is correct? Unfortunately, there is no clear answer. All economists agree that firms will not hire workers who cost more per hour than the value of their hourly output. So there is some minimum wage so high that it would severely reduce employment. Consider $20 an hour, as an absurd example. Economists generally think a 10 percent increase in the minimum wage will reduce employment of unskilled workers by about 1 to 3 percent. But no current consensus exists on the employment effect of the present level of the minimum wage.

The overall effect of the minimum wage is thus uncertain. There seems to be a consensus emerging that, on the one hand, the employment and unemployment effects of the minimum wage are not as great as many critics fear. On the other hand, because a large part of its effect is dissipated on nonpoverty families, the minimum wage is not as strong an antipoverty tool as many supporters contend.

Voting patterns and surveys make it clear, however, that the minimum wage has strong political support. Perhaps this stems from two realities: (1) More workers are believed to be helped than hurt by the minimum wage, and (2) the minimum wage gives society some assurance that employers are not “taking undue advantage” of vulnerable, low-skilled workers.

Question: Have you ever worked for the minimum wage? If so, for how long? Would you favor increasing the minimum wage by $1? By $2? By $5? Explain your reasoning.

Summary 1. The demand for labor is derived from the product it helps produce. That means the demand for labor will depend on its productivity and on the market value (price) of the good it is producing.

2. Because the firm equates the wage rate and MRP in determining

its profit-maximizing level of employment, the marginal revenue product curve is the firm's labor demand curve. Thus, each point on the MRP curve indicates how many labor units the firm will hire at a specific wage rate.

3. The competitive firm's labor demand curve slopes downward because of the law of diminishing returns. Summing horizontally the demand curves of all the firms hiring that resource produces the market demand curve for labor.

4. The demand curve for labor will shift as the result of (a) a change in the demand for, and therefore the price of, the product the labor is producing; (b) changes in the productivity of labor; and (c) changes in the prices of substitutable and complementary resources.

5. The elasticity of demand for labor measures the responsiveness of labor quantity to a change in the wage rate. The coefficient of the elasticity of labor demand is

When Ew is greater than 1, labor demand is elastic; when Ew is less than

1, labor demand is inelastic; and when Ew equals 1, labor demand is

unit-elastic.

6. The elasticity of labor demand will be greater (a) the greater the ease of substituting other resources for labor, (b) the greater the elasticity of demand for the product, and (c) the larger the proportion of total production costs attributable to labor.

7. Specific wage rates depend on the structure of the particular labor market. In a competitive labor market the equilibrium wage rate and level of employment are determined at the intersection of the labor supply curve and labor demand curve. For the individual firm, the market wage rate establishes a horizontal labor supply curve, meaning

that the wage rate equals the firm's constant marginal resource cost. The firm hires workers to the point where its MRP equals its MRC.

8. Under monopsony, the marginal resource cost curve lies above the resource supply curve because the monopsonist must bid up the wage rate to hire extra workers and must pay that higher wage rate to all workers. The monopsonist hires fewer workers than are hired under competitive conditions, pays less-than-competitive wage rates (has lower labor costs), and thus obtains greater profit.

9. A union may raise competitive wage rates by (a) restricting the supply of labor through exclusive unionism or (b) directly enforcing an above-equilibrium wage rate through inclusive unionism. On average, unionized workers realize wage rates 15 percent higher than those of comparable nonunion workers.

10. Wage differentials are largely explainable in terms of (a) marginal revenue productivity of various groups of workers; (b) noncompeting groups arising from differences in the capacities and education of different groups of workers; and (c) compensating wage differences, that is, wage differences that must be paid to offset nonmonetary differences in jobs.

11. Economists disagree about the desirability of the minimum wage. While it raises the income of some workers, it reduces the income of other workers whose skills are not sufficient to justify being paid the mandated wage.

Terms and Concepts purely competitive labor market derived demand marginal revenue product (MRP) marginal resource cost (MRC) MRP = MRC rule substitution effect output effect

elasticity of labor demand monopsony exclusive unionism occupational licensing inclusive unionism wage differentials human capital compensating differences

Study Questions 1. Explain the meaning and significance of the fact that the demand for labor is a derived demand. Why do labor demand curves slope downward? LO1

2. On the following page, complete the labor demand table for a firm that is hiring labor competitively and selling its product in a purely competitive market. LO1

a. How many workers will the firm hire if the market wage rate is $11.95? $19.95? Explain why the firm will not hire a larger or smaller number of units of labor at each of these wage rates.

b. Show in schedule form and graphically the labor demand curve of this firm.

3. Suppose that marginal product tripled while product price fell by one-half in the table in Figure 10.1. What would be the new MRP values in the table? What would be the net impact on the location of the labor demand curve in Figure 10.1? LO2

4. In 2002 Boeing reduced employment by 33,000 workers due to reduced demand for aircraft. What does this decision reveal about how it viewed its marginal revenue product (MRP) and marginal resource cost (MRC)? Why didn't Boeing reduce employment by more than 33,000 workers? By less than 33,000 workers? LO2

5. How will each of the following affect the demand for resource A, which is being used to produce commodity Z? Where there is any uncertainty as to the outcome, specify the causes of that uncertainty. LO2

a. An increase in the demand for product Z.

b. An increase in the price of substitute resource B.

c. A technological improvement in the capital equipment with which resource A is combined.

d. A fall in the price of complementary resource C.

e. A decline in the elasticity of demand for product Z due to a

decline in the competitiveness of product market Z.

6. What effect would each of the following factors have on elasticity of demand for resource A, which is used to produce product Z? LO3

a. There is an increase in the number of resources substitutable for A in producing Z.

b. Due to technological change, much less of resource A is used relative to resources B and C in the production process.

c. The elasticity of demand for product Z greatly increases.

7. Florida citrus growers say that the recent crackdown on illegal immigration is increasing the market wage rates necessary to get their oranges picked. Some are turning to $100,000 to $300,000 mechanical harvesting machines known as “trunk, shake, and catch” pickers, which vigorously shake oranges from the trees. If widely adopted, how will this substitution affect the demand for human orange pickers? What does that imply about the relative strengths of the substitution and output effects? LO2

8. Why is a firm in a purely competitive labor market a wage taker? What would happen if it decided to pay less than the going market wage rate? LO4

9. Complete the following labor supply table for a firm hiring labor competitively: LO4

a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Explain the relationship of these curves to one another.

b. Plot the labor demand data of question 2 on the graph used in part a above. What are the equilibrium wage rate and level of employment? Explain.

10. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage rate by $3 to attract each successive worker. Draw the firm's labor supply and marginal resource cost curves and explain their relationships to one another. On the same graph, plot the labor demand data of question 2. What are the equilibrium wage rate and level of employment? Why do these differ from your answer to question 9? LO4

11. Contrast the methods used by inclusive unions and exclusive unions to raise union wage rates. LO5

12. What is meant by the terms “investment in human capital” and “compensating wage differences”? Use these concepts to explain wage differentials. LO6

13. Why might an increase in the minimum wage in the United States simply send some jobs abroad? Relate your answer to elasticity of labor demand. LO3

FURTHER TEST YOUR KNOWLEDGE AT www.mcconnellbriefmicro1e.com

Web-Based Questions At the text's Online Learning Center, www.mcconnellbriefmicro1e.com, you will find a multiple-choice quiz on this chapter's content. We encourage you to take the quiz to see how you do. Also, you will find one or more Web-based questions that require information from the Internet to answer.

1 Note that we plot the points in Figure 10.1 halfway between succeeding numbers of labor units. For example, we plot the MRP of the second unit ($12) not at 1 or 2 but at 1½. This “smoothing” enables us to sketch a continuously downsloping curve rather than one that moves downward in discrete steps as each new unit of labor is hired.

(McConnell 217)

McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill Learning Solutions, 2010. .

11: Income Inequality and Poverty IN THIS CHAPTER YOU WILL LEARN:

1 How income inequality in the United States is measured and described.

2 The extent and sources of income inequality.

3 How income inequality has changed since 1970.

4 The economic arguments for and against income inequality.

5 How poverty is measured and its incidence by age, gender, ethnicity, and other characteristics.

6 The major components of the income-maintenance program in the United States.

Evidence that suggests wide income disparity in the United States is easy to find. In 2007 talk-show host Oprah Winfrey earned an estimated $260 million, golfer Tiger Woods earned $100 million, and rapper and music executive Jay-Z earned $83 million. In contrast, the salary of the president of the United States is $400,000, and the typical schoolteacher earns $47,000. A full-time minimum-wage worker at a fast-food restaurant makes about $11,000. Cash welfare payments to a mother with two children average $5000.

In 2006 about 36.5 million Americans—or 12.3 percent of the population— lived in poverty. An estimated 500,000 people were homeless in that year. The richest fifth of American households received about 50.5 percent of total income, while the poorest fifth received less than 4 percent.

What are the sources of income inequality? Is income inequality rising or falling? Is the United States making progress against poverty? What are the major income-maintenance programs in the United States? Is the current welfare system effective? These are some of the questions we will answer in this chapter.

Facts about Income Inequality Average household income in the United States is among the highest in the world; in 2006, it was $66,570 per household (one or more persons occupying a housing unit). But that average tells us nothing about income inequality. To learn about that, we must examine how income is distributed around the average.

Distribution by Income Category One way to measure income inequality is to look at the percentages of households in a series of income categories. Table 11.1 shows that about 25.2 percent of all households had annual before-tax incomes of less than $25,000 in 2006, while another 19.1 percent had annual incomes of $100,000 or more. The data in the table suggest a wide dispersion of household income in the United States.

income inequality

The unequal distribution of an economy's total income among households or families.

TABLE 11.1: The Distribution of U.S. Income by Households, 2006

Distribution by Quintiles (Fifths) A second way to measure income inequality is to divide the total number of individuals, households, or families (two or more persons related by birth, marriage or adoption) into five numerically equal groups, or quintiles, and examine the percentage of total personal (before-tax) income received by each quintile. We do this for households in the table in Figure 11.1, where we also provide the upper income limit for each quintile. Any amount of income greater than that listed in each row of column 3 would place a household into the next-higher quintile. FIGURE 11.1: The Lorenz curve and Gini ratio.

The Lorenz curve is a convenient way to show the degree of income inequality (here, household income by quintile in 2006). The area between the diagonal (the line of perfect equality) and the Lorenz curve represents the degree of inequality in the distribution of total income. This inequality is measured numerically by the Gini ratio— area A (shown in gold) divided by area A + B (the gold + gray area). The Gini ratio for the distribution shown is 0.470.

Source: Bureau of the Census, www.census.gov.

The Lorenz Curve and Gini Ratio

We can display the quintile distribution of personal income through a Lorenz curve. In Figure 11.1, we plot the cumulative percentage of households on the horizontal axis and the cumulative percentage of income they obtain on the vertical axis. The diagonal line 0 e represents a perfectly equal distribution of income because each point along that line indicates that a particular percentage of households receive the same percentage of income. In other words, points representing 20 percent of all households receiving 20 percent of total income, 40 percent receiving 40 percent, 60 percent receiving 60 percent, and so on, all lie on the diagonal line.