Intermediate Macroeconomics Questions, due on April 29, 3:00pm (UTC+8)

Occupational and Income Inequality in Labour Markets

Part I

1. Second part of the course.

a) Revisiting the key objectives

The main objectives of this class:

· Documenting the increasing economic inequality in recent decades,

· Dissecting the key sources of economic inequality,

· Explaining these phenomena through economic models.

b) Reviewing what we have already done

We have explained the following phenomena:

· Regional income inequality across provinces has decreased,

· Income disparities across FNRs have widened due to the partial implementation of modern treaties,

· Income disparities between large CMRs and small cities/towns have increased.

c) Roadmap

In the second part of the course, we will attempt to explain two phenomena:

· the shrinking middle class,

· the disappearance of good jobs.

To this end, will focus on the functional distribution of income inequality by:

· distinguishing between capital vs. labour income,

· explaining individuals’ self-selection into different occupations and the presence of involuntary unemployment.

We will also explore the role of redistributive government policies in offsetting the impact of increasing market income inequality.

2. Introduction.

a) Overview

In this lecture, we will explore how the functional distribution of income has contributed to increased income inequality in recent decades.

Figure 1

Source: IRPP (2016)

In the first part of this lecture, we will build a labour market model, in which we distinguish between capitalists (firm owners) and workers.

The objective of our model is to explain three key facts:

· Declining labour share of income (Figure 1),

· Increasing within-provincial income inequality (Figure 2),

· Rising standard of living.

Figure 2

Source: IRPP (2016)

3. Labour market.

a) Voluntary transactions and markets

A voluntary exchange is a transaction where two people trade goods or services freely in the sense that there is no coercive or restrictive force involved in the transaction. Both parties want to make the exchange of items, and both parties will benefit from the trade.

In a labour market, a worker offers labour services, for which they are paid a wage. A capitalist receives revenue from the sale of goods and services produced using labour services and incurs a cost by paying a wage to a worker.

· Worker’s decision-making

Workers have a reservation wage, above which they are willing to accept an offer of employment and below it they decline it.

A reservation wage could be the wage at one’s current job or the social assistance payments one receives.

Accept employment if and reject if .

· Firm’s decision making

A firm owned by a capitalist hires a worker if the revenue it generates from employing the worker exceeds the wage the firm pays to the worker. The profit is automatically generated as income to the

Example:

Consider a simple example, in which each firm hires one worker.

Table 1

Firm	Revenue from hiring worker	Reservation Wage	Potential gains from employment	Transaction (Employment)
1	30	12	18	Yes
2	25	16	9	Yes
3	20	20	0	Yes
4	15	24	-9	No

b) Labour demand and labour supply

It is often convenient to graphically represent the willingness of firms and workers to engage in employment.

Labour supply curve – a curve that represents the reservation wage for each additional worker.

Labour demand curve – a curve that represents the revenue from employing a worker.

The labour supply curve and the labour demand curve could also be expressed as equations. This type of representation will also provide us with the opportunity to calculate the income distribution between capitalists (firm owners) and workers.

Labour demand curve:

intercept

slope coefficient

For the numerical example at hand, and .

Labour supply curve:

intercept

slope coefficient

For the numerical example at hand, and .

c) Labour market equilibrium

The labour market equilibrium occurs at the intersection point of the labour demand curve and the labour market curve.

An equilibrium labour – the number of employed workers.

An equilibrium wage – the prevailing wage

Figure 3

In general, we must solve a system of two equations with two unknowns.

In equilibrium (actual outcome), workers are employed at .

d) Income inequality

· Workers’ income

The income earned by (all) workers is given by:

Note: The per worker income is

· Capitalists’ income

The income earned by (all) capitalists is given by the profit (revenue minus cost). The revenue to the firm is represented by the demand curve and the cost by . In a graph, this area is captured by the triangle A.

Figure 4

4. Policy debates.

a) Overview

A main policy debate in previous decades has been whether re-invested profit by the capitalists will generate widely shared gain to the economy.

This policy debate could be broken down into two components:

· Will total income rise?

· How will income gains be distributed between capitalists and workers?

b) Impact of re-investing profit

Profit could be re-invested as new capital. This is equivalent to an outward shift of the labour demand curve.

We will show that more re-invested profit always leads to a higher total income. Its redistributive impact depends on the shape of the labour supply and the labour demand curves.

We will consider the extreme cases of a horizontal labour supply curve, which captures two ideas:

· All workers have the same reservation wage,

· There is an abundant labour force.

· Horizontal labour supply curve

Table 3

Firm	Revenue from hiring worker	Reservation Wage	Potential gains from employment	Transaction (Employment)
1	30	20	10	Yes
2	25	20	5	Yes
3	20	20	0	Yes
4	15	20	-5	No
5	10	20	-10	No
6	5	20	-15	No

For the numerical example at hand, and . That is, the labour supply curve is given by and the labour demand curve by .

In equilibrium (actual stable outcome), workers are employed at .

Figure 5

· Income distribution

The income distribution is identical to the one we have already found.

The income earned by (all) workers is given by:

Note: The per worker income is

The income earned by (all) capitalists is given by the profit (revenue minus cost). The revenue to the firm is represented by the demand curve and the cost by . In a graph, this area is captured by the triangle A.

Suppose that these 22.5 units of income are re-invested, which results in the following outward shift in the demand curve.

Table 4

Firm	Revenue from hiring worker	Reservation Wage	Gains from hiring worker	Transaction (Employment)
1	40	20	20	Yes
2	35	20	15	Yes
3	30	20	10	Yes
4	25	20	5	Yes
5	20	20	0	Yes
6	15	20	-5	No

The demand curve shifts up due to the re-invested profit to . The labour supply curve given by remains unchanged.

In equilibrium, workers are employed at .

The income earned by (all) workers is given by:

Note: The per worker income is

The income earned by (all) capitalists is given by the profit (revenue minus cost). The revenue to the firm is represented by the demand curve and the cost by . In a graph, this area is captured by the triangle A.

Figure 6

· Functional income distribution

Table 5 describe the income distribution before and after the re-investment of profit.

Table 5

Functional income distribution	Income share of capitalists	Income share of workers
Before re-investing profit
After re-investing profit

We were able to simultaneous explain the following key facts:

· Total income increased,

· The labour share of income declined.

If capitalists and workers live in the same province, we are also to provide a key explanation as to why within-provincial income inequality increased.

c) Role of immigration policy

· Key immigration policies

Did the shape of the labour supply curve change?

It is plausible that the labour supply curve may have been steeper in previous decades and have become flatter.

Three potential sources related to immigration policy:

· Increased immigration,

· Change in the type of immigration from permanent residents (PRs) to temporary foreign workers (TFWs) in the last two decades.

· A large share of TFWs are tied to a specific employer.

· Economic impact

The increased immigration would result in a rightward shift in the labour supply curve. That is, for each wage there are more potential workers willing to accept employment.

A greater reliance on TFWs reduces the reservation wage of those workers relative to them being admitted as PRs. This generates a pivot of the labour supply curve, which becomes flatter.

· Evidence

Figure 7 indicates the admission of both PRs and TFWs increased in recent decades.

In general, the admission of both PRs and TFWs is closely tied to economic fluctuations (reduced admissions during recessions and increased admissions during economic recovery and booms).

Figure 7

Source: IRPP (2013)

Each of the two curves experience a structural change in response to a major immigration policy change:

· From 1985 to 1992, the admission of PRs sharply increased.

· From 2005 to 2011, the admission of TFWs sharply increased, while the admission of PRs remains relatively constant (subject to cyclical fluctuations).

Figure 8 presents some evidence on the impact of tying TFWs to a specific employer. We will analyze the impact om earnings of high-skilled whose wages are unlikely to have been influenced by part-time employment and/or minimum wage policies.

The time trends reveal that the earnings for high-skilled individuals with a work permit tied to an employer declined over the examined period (2001 – 2016).

Figure 8

Source: Statistics Canada (2019)

The time trend exhibits a structural break around 2008, which highlights that the income of high-skilled workers declined during the boom times prior to the Great Recession and partially recovered after that.

This evidence highlights that tying TFWs to a specific employer reduces their earnings during periods when they should have been increasing (if following the trend for the general population).

The increasing number of TFWs and their declining earnings are also likely to have had a spillover effect on the earnings of citizens and PRs.

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