Demand for Labor and Minimum Wage

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12 Marginal Productivity Theory and Labor Markets

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Learning Outcomes

After reading this chapter, you should be able to

• Explain what makes the demand for labor different from the demand for final goods.

• Describe how a profit-maximizing firm in pure competition decides how much labor to employ in terms of its marginal revenue product and marginal resources cost.

• Use a resource market diagram to illustrate the use of labor under pure competition versus monopoly in the product market.

• Determine the factors that affect the elasticity of demand for labor and describe possible causes for a shift in the demand for labor.

• Explain the role of productivity, race, and comparable worth in determining labor income.

258

Section 12.1 Special Features of the Demand for Labor

Introduction After decades of efforts to reduce immigration, the net flow across the U.S.–Mexico bor- der reversed in 2005. By 2018 there weren’t enough new immigrants to satisfy California’s demand for agricultural workers. Employing almost 500,000 farmworkers, California was left with a different kind of drought than it was used to facing: a drought in the immigrant labor force.

As the supply of labor continued to fall, wages for crop production in California climbed 13% from 2010 to 2015. The increase in wages has incentivized farmers to make changes to their production strategies. In some cases, farmers have substituted less labor-intensive crops for the more labor-intensive counterparts—for example, switching from grapes and vegetables to almonds.

Other farmers have chosen to invest in agricultural technology (so-called ag-tech). For exam- ple, a firm called Ramsay Highlander developed a robotic machine that uses a band saw to “mow” rows of baby lettuce and other greens like cabbage and celery. The machine reduced the need for labor by about 60%. However, for asparagus, which requires careful hand and knife harvesting, this may not be a solution; asparagus-harvesting machines have failed to replicate human dexterity.

Economists predicted that these changes would occur, primarily increased wages and greater mechanization in production techniques, far in advance of actually observing the reduced immigration resulting from additional crackdowns. This chapter will explain how economists knew what the future agricultural labor market would look like and why.

12.1 Special Features of the Demand for Labor Earlier in this book, we examined the circular flow of a basic economy. It shows the firm involved in two markets: the product market and the resource market. Figure 12.1 repro- duces the circular flow diagram from Chapter 2. We have studied the theory of the firm in the product market, the upper half of the circular flow diagram. We now turn our attention to the theory of the firm in the largest part of the resource market, the labor market.

259

Section 12.1 Special Features of the Demand for Labor

The demand for labor is similar to other types of demand we have studied. In earlier chapters, we described product markets, in which firms or individuals sell the goods and services they produce to consumers. Now we will examine the labor market, the market in which firms buy—or rent—the services of labor from individuals. We can adopt many of the same analyti- cal tools we used to study product markets. There are, however, some differences between labor and product markets, and we will concentrate on these differences.

The demand for labor has three features that make it somewhat different from the demand for a product. The first is that the demand for labor is derived demand. A firm demands labor because the labor can be used to produce goods that consumers are demanding. The demand for labor is thus derived from the demand for the product the firm produces. If there were no consumer demand for products made from wood, there would be no demand for loggers. This principle holds for all productive resources. They are only valuable to a firm if they help produce products that consumers value.

Figure 12.1: The circular flow of income

Households purchase goods and services and supply land, labor, capital, and enterprise. Firms buy these productive resources and supply goods and services. In the product market, buyers and sellers exchange goods and services. In the resource market, buyers and sellers exchange the services or productive resources.

Go ods and services

Co ns

um er s

pend ing for goods and servicesP

ROD UCT MARKET

Labor, land, capital, and en

ter pr

is e

Wages, rent, interest, and pro

fit

RESOURCE MAR KE

260

Section 12.2 The Market for Labor With Perfect Competition

The second feature of the demand for labor is that it is interdependent demand. It depends on the demand for other inputs. In other words, the amount of labor demanded will depend on the amounts of other inputs a firm plans to use. The amount of labor a firm demands depends on the amounts of land, capital, and enterprise that will be used in combination with the labor. It is also true that the demand for most products is interdependent with the demand for other products. Recall that almost all goods have substitutes, and many goods have complements. However, the interdependence of the demand for labor with the demand for other productive resources is unusual in that the other resources can be both comple- ments and substitutes at the same time.

The third feature is that the demand for labor is in part technologically determined demand. That is, the demand for labor will depend on techniques of production and on technologi- cal progress, or the production function. Recall that the production function tells how much labor is needed to produce a certain level of output, given a certain production process and amounts of the other productive resources of production. This technological relationship can change with new inventions and new innovations. Any change resulting in a new technology or a new innovation will have an impact on the demand for productive resources, including labor.

These three elements are combined in marginal productivity theory, which was originally developed by John Bates Clark. Marginal productivity theory explains how the distribution of income is determined in a market system. Each input is paid according to its contribution, or its marginal productivity. The more productive inputs will be paid more. We will follow Clark’s lead by developing marginal productivity theory in terms of labor supply and demand.

Check Point: Special Characteristics of Resource Markets

• Demand is derived from the demand for the final product. • Demand is interdependent with demand for other inputs. • Demand is technologically determined.

12.2 The Market for Labor With Perfect Competition Remember that a demand curve shows the relationship between price and quantity demanded. A demand curve for labor shows how much labor will be demanded at various wage rates. In order to develop a theory about the market demand for labor, we start by asking how much labor an individual firm will employ at various wage rates. Then we horizontally sum the quantities for all firms in the same way we added individual demand curves to find the mar- ket demand for a product.

261

Section 12.2 The Market for Labor With Perfect Competition

Demand for Labor What determines the firm’s demand for labor? Suppose the production function is such that, as the firm increases the amount of labor employed, assuming everything else remains the same, the resulting increases in the amount of total product become smaller. This production function reflects the principle of diminishing marginal productivity, which we discussed in an earlier chapter. Holding constant the quantities of land and capital, it is possible to determine how the firm’s output varies with the quantity of labor it uses. As the firm employs more labor in combination with fixed amounts of the other inputs, the additional amounts of output per additional unit of labor eventually decline. If this were not the case, it would be theoretically possible to grow the entire world’s supply of wheat on 1 acre of land just by employing more workers.

Consider a farmer selling corn in a perfectly competitive product market and also buying labor in a perfectly competitive labor market. This means that the farmer will take both the price of the farm’s product and the price of labor as given. Table 12.1 shows the total product (or total amount of corn) associated with various amounts of labor inputs for the farm. This output depends on the technical relationship defined by the production function. Once we know the total product, we can determine how much extra product is produced when labor inputs are added. That value is the marginal product of that unit of labor (MPL). It is the mar- ginal product because the output is in physical units, such as number of autos, tons of coal, or bushels of corn.

Table 12.1: The demand for labor in a perfectly competitive product market

Units of labor

Total product

Marginal product of labor (MPL)

Product price

Total revenue

Value of marginal product of labor (VMPL)

Marginal revenue product of labor (MRPL)

0 0 0 $2 $0 $0 $0

1 10 10 2 20 20 20

2 18 8 2 36 16 16

3 24 6 2 48 12 12

4 28 4 2 56 8 8

5 30 2 2 60 4 4

To put a market value on the additional output, we simply multiply the number of added units of the product by the price at which the firm can sell it. This value is called the value of the marginal product of labor (VMPL). It is listed in the sixth column of Table 12.1. The VMPL, which is P × MPL, is a measure of the value of the additional output that each additional unit of labor adds to the firm’s total. The marginal revenue product of labor (MRPL) is the amount

262

Section 12.2 The Market for Labor With Perfect Competition

that an additional unit of labor adds to the firm’s total revenue. It is found in the seventh col- umn of Table 12.1. It is found by multiplying MR by MPL. With perfect competition in the prod- uct market, VMPL = MRPL. These values are equal because the product price remains constant (P = MR). The firm can produce and sell as much as it wants at the market-determined price, which is $2 in this example. When the firm faces a given price, marginal revenue is exactly equal to that price in the model of perfect competition. Later in this chapter, we will look at how the value of the marginal product and the marginal revenue product differ when there is monopoly power in the product market.

The values of VMPL and MRPL from Table 12.1 are plotted on a graph in Figure 12.2. The MRPL curve is the firm’s demand curve for labor. It shows the value of each additional unit of labor to the firm. Thus, it shows how much labor the firm will purchase at various prices (wage rates). If you know the price of labor, you will be able to determine how much labor this firm will demand.

Economics in Action: Behind Farm to Table: The Labor of Farming

Watch a panel of farmers, chefs, and farm advocates address the challenges of 21st-century farming, including attracting a younger generation to this notoriously difficult field: https:// youtu.be/jLFFfBkiD9M.

Figure 12.2: The farmer’s demand for labor in a perfectly competitive product market

The marginal revenue product of labor (MRPL) curve is the farmer’s demand curve for labor. When the product market is perfectly competitive, MRPL and VMPL are identical.

63 5421

Price, cost

Quantity/ time period

VMP L = MRP

L = D

https://youtu.be/jLFFfBkiD9M

263

Section 12.2 The Market for Labor With Perfect Competition

Supply of Labor An individual’s supply curve of labor looks like the other supply curves we have considered. As wage rates rise, the quantity of labor supplied increases. This supply curve of labor, like most supply curves, is upward sloping. As wage rates rise, an individual will want to work more hours. In general, as wages rise, more people will choose to give up leisure in favor of more income. The trade-off between earning income or consuming leisure is the substitution effect of a wage increase. As wages rise, individuals will substitute the increased consump- tion of goods and services, represented by higher wages, for leisure. This substitution effect occurs along the upward-sloping portion of Figure 12.3.

Figure 12.3: An individual’s labor supply curve

When wages rise, the substitution effect for an individual exceeds the income effect, making the labor supply curve upward sloping. The quantity of labor supplied increases as wages increase. Up to some point, the income effect dominates. Above that point, a wage of $40 per hour here, further increases in the wage rate cause the quantity of labor supplied to decrease.

$40

$30

$20

Wage rate (dollars/hour)

Quantity of labor supplied (hours/week)

There is also an income effect associated with the increased income brought about by a wage increase. Individuals want to consume more leisure at higher incomes because leisure is a normal good. The income effect of a higher wage is that individuals want to supply a lower quantity of labor. At some point, the income effect of a wage increase could dominate the sub- stitution effect. In that case an increase in the wage rate would bring about a decrease in the quantity of labor supplied. This is represented by the crook in the individual’s supply curve in Figure 12.3. For this individual, an increase in the wage rate above $15 per hour causes the quantity of labor supplied to decrease. Economists refer to a supply curve with this shape as a backward-bending supply curve. It is important to keep in mind that this is an individual supply curve. Where the bend occurs is an individual decision. For example, some entertain- ers perform less as they get more famous. Others appear to keep increasing the quantity of labor supplied as their wage rate increases.

264

Section 12.2 The Market for Labor With Perfect Competition

The market supply curve of labor is the aggregate of all the individual supply curves. It shows how much labor is available at different wage rates. Figure 12.4 shows a perfectly competitive labor market. This market supply curve is not backward bending, because more workers will enter the market at higher wage rates, and different individuals have different opportunity costs and will make choices resulting in different substitution effects and income effects. In other words, higher wages are needed to attract additional workers who have higher oppor- tunity costs.

Figure 12.4: Perfectly competitive labor market

In a perfectly competitive labor market, the firm faces a perfectly elastic supply curve (Sf). If the supply curve is perfectly elastic, the marginal resource cost (MRCL) curve is also perfectly elastic. The firm can purchase as much labor as it wants at the market-determined wage rate.

0 Quantity/ time period

Quantity/ time period

Price, cost

(a) Firm (b) Market

W* W*

x 1

S L

MRP L

D L

Perfect competition in the labor market means the firm can purchase labor at the market wage without affecting that wage. In this sense the firm is a wage taker, just like the perfectly competitive firm was a price taker in the product market. The equilibrium wage rate is W* in Figure 12.4. The firm can purchase as much labor as it wants at the wage rate W*.

Equilibrium in the Perfectly Competitive Labor Market A profit-maximizing firm will employ additional labor until the cost of an additional unit is equal to the benefit, which is when the marginal product of labor is equal to the equilibrium wage (MRPL = W*). If a unit of labor adds more to revenue than to cost (if MRPL > W*), it will be profitable for the firm to purchase more units of labor. However, if a unit of labor adds more to cost than to revenue (if MRPL < W*), the firm should employ fewer units. The firm will hire laborers until the amount they add to total cost (W*) is exactly equal to the amount they add to revenue (MRPL). In Figure 12.4 the firm would employ x1 units of labor at wage rate W*. In terms of the numbers in Table 12.1, the firm would employ 4 units of labor if the market wage was $8 per unit. If the market wage was $4 per unit, 5 units of labor would be employed.

265

Section 12.3 A Competitive Labor Market With a Monopolistic Product Market

12.3 A Competitive Labor Market With a Monopolistic Product Market

Now consider a farmer who has the sole rights to sell a highly specialized variety of corn; the farmer operates as a monopoly for this reason. The farm’s demand for labor is shown in Table 12.2. The difference between this case and the firm of the preceding section is that a monopo- list faces a downward-sloping demand curve. Thus, the product price (in the fourth column of Table 12.2) declines as the firm produces and sells more of its product. VMPL and MRPL are calculated in the same way as before. VMPL is the value of the labor’s marginal product, so VMPL = MPL × P. MRPL is found by calculating the change in total revenue due to additional units of labor. For example, when the third worker is added, total revenue rises from $162 to $192. Thus, MRPL for the third worker is $192 – $162 = $30. Note that VMPL is greater than MRPL for all but the first unit of labor, because in a monopoly, product price is greater than marginal revenue.

Table 12.2: The demand for labor in a monopolistic product market

Units of labor

Total product

Marginal product of labor

(MPL) Product

price Total

revenue

Value of marginal product of labor (VMPL)

Marginal revenue product of labor (MRPL)

0 0 — $0 $0 — —

1 10 10 10 100 $100 $100

2 18 8 9 162 72 62

3 24 6 8 192 48 30

4 28 4 7 196 28 4

5 30 2 6 180 12 –16

Both the VMPL curve and the MRPL curve are graphed in Figure 12.5 using the data from Table 12.2. The MRPL curve is the monopolist’s demand curve for labor. A monopoly firm, like the perfectly competitive firm, will employ labor until MRPL = W*. Although this firm operates as a monopoly when it sells the specialized corn, it is still purchasing labor in a competitive labor market.

266

Section 12.3 A Competitive Labor Market With a Monopolistic Product Market

The supply and demand curves for the monopolist in the competitive labor market are dia- grammed in Figure 12.6. The market demand curve for labor is, as usual, found by summing the MRPL curves for all firms purchasing this type of labor. The market supply curve (SL) is the sum of individual supply curves of workers. The market-determined wage is W. This firm can purchase as much labor as it desires at W, since the supply curve it faces, Sf, is perfectly elastic at W.

Figure 12.5: The monopolist’s demand for labor

When a firm has a monopoly power in the product market, the MRPL will lie below VMPL. This is because product price is greater than marginal revenue under monopoly. Thus, P × MPL is greater than MR × MPL.

Price, cost

Quantity/ time period

MRP L = D

VMP L

Figure 12.6: A monopolistic firm facing a perfectly competitive labor market

A firm with monopoly power, like a firm in a perfectly competitive market, can purchase as much labor as it wants at the market-determined wage rate. The difference is seen in (a), where the firm may choose to purchase fewer units than a perfectly competitive firm because MRPL < VMPL.

0 Quantity/ time period

Quantity/ time period

Price, cost

(a) Firm (b) Market

W* W*

x 2

x 1

S L

D L = ∑ MRP

VMP L

MRP L = D

267

Section 12.4 Determinants of the Demand for Labor

Again, the profit-maximizing firm equates the marginal benefit of labor (MRCL) to the mar- ginal cost of labor (W*), so it hires x1 units of labor. Note from Figure 12.6 that the monopo- list pays W*, the market wage. The fact that MRPL is less than VMPL does not mean that the monopolist exploits labor by paying too little. The monopolist has to pay the market wage just like any other employer in this market. Because MRPL is less than VMPL, the monopolist does employ fewer workers than more competitive firms would employ. Recall from Chapter 11 that the monopolist restricts the quantity of output available to keep price high. The result of this restriction of output in the resource market is that the monopolist uses fewer inputs overall, including labor. If this were a competitive firm rather than a monopolist, the firm would hire x2 workers.

12.4 Determinants of the Demand for Labor At the beginning of this chapter, you learned that the demand for labor has additional features that make it somewhat different from the demand for a product. These features also influ- ence the elasticity of the demand for labor, because they determine how the quantity of labor demanded will respond to changes in the wage rate. In other words, the demand for labor has a price elasticity, just as the demand for products does. This elasticity is influenced by the distinguishing features of the demand for labor.

Share of Labor Input Costs First, assume that only labor is used to produce the product sold by the firm, such as a food delivery service. Labor costs in this case are close to 100% of product cost. If the price of labor falls 10%, the cost of production falls 10%, and price (in perfect competition) falls 10%. Now, more realistically, let labor costs constitute only 50% of product cost. Then if the price of labor falls 10%, the cost of production falls only 5%. In other words, the larger the share of labor cost in total production cost of a product, the more a change in the wage rate will affect the cost of production and the price of the product. As a result, the larger the share of the total cost of production that wages represent, the greater the elasticity of demand for labor will be.

Policy Focus: U.S. Immigration Policy

Give me your tired, your poor, Your huddled masses yearning to breathe free, The wretched refuse of your teeming shore, Send these, the homeless, tempest-tossed to me, I lift my lamp beside the golden door!

—Inscription on the Statue of Liberty

The United States is a country of immigrants and descendants of immigrants—a “melting pot,” as you may have heard in elementary school. In the early 19th century, Europeans, mostly from western Europe, flooded into the United States. In the late 19th century, a wave

(continued)

268

Section 12.4 Determinants of the Demand for Labor

of Chinese immigrated to California. In the early 20th century, a huge flood of immigrants arrived from southern and eastern Europe. The most recent large waves of immigrants have been from Southeast Asia, after the end of the Vietnam War, and from Central America.

Each influx of immigrants caused a great debate among Americans who were already citizens. The issue was always the same—whether to shut the door to new immigrants. Often the answer was yes, and new restrictions were passed. Many legal restrictions on immigration are racist in origin. Many groups support immigration of those who are like themselves but are opposed to altering the racial mix of the country.

There is at least one economic motive for restricting immigration. Immigration makes the supply of labor more elastic for each skill level, putting downward pressure on wage rates. It isn’t surprising that organized labor groups are often opposed to liberalizing immigration. In fact, some states even prohibit the transfer of certain occupational skills within the United States. For example, an attorney in Wisconsin who plans to migrate to Oregon will not be licensed until he or she passes the Oregon bar exam. This requirement clearly reduces the supply of legal services in Oregon. As a result, attorneys in Oregon have higher incomes than they would otherwise.

By 2018 nearly 34 million lawful immigrants were living in the United States. Many have been granted permanent status (referred to as a green card) or have temporary visas as students or workers. Another 1 million immigrants are unauthorized but have limited permission to live and work in the United States. One of those programs is the Consideration of Deferred Action for Childhood Arrivals (DACA). President Barack Obama created DACA through a 2012 executive order. The program has allowed hundreds of thousands of young people who were brought to the United States illegally as children to remain in the country. Applicants cannot have serious criminal histories and must have arrived in the United States before 2007, when they were under age 16. DACA recipients can live and work legally in the United States for renewable 2-year periods.

As of 2017 roughly 800,000 so-called Dreamers have applied to join the initiative. On September 5, 2017, President Donald Trump ended DACA by halting all new applications for legal status through the program. Although the Justice Department allowed current DACA recipients to apply for a 2-year renewal, all DACA authorizations will expire at the end of the 2-year span, with the last authorization ending in March 2020 (U.S. Citizenship and Immigration Services, 2018).

Trump’s decision to end the program set off protests across the United States and was met with a flurry of criticism from Democratic leaders, including former president Obama (2017), who posted on Facebook:

To target these young people is wrong—because they have done nothing wrong. It is self-defeating – because they want to start new businesses, staff our labs, serve in our military, and otherwise contribute to the country we love. And it is cruel. (para. 5)

Some experts have said the program could end up covering 1.3 million young people if it were allowed to continue (Pew Research Center, 2018). How would these DACA recipients impact the labor market in the United States? The effect would be negligible, since roughly 257 million people were employed in the labor market in 2018 (Bureau of Labor Statistics, 2018b). However, to the DACA recipients, it would make all the difference in the world.

Policy Focus: U.S. Immigration Policy (continued)

269

Section 12.4 Determinants of the Demand for Labor

Opportunities for Input Substitution For firms that produce physical goods, a great deal of substitution among the produc- tive resources is possible. The choice of which combination of productive resources to use depends, as you learned earlier, on the prices of those inputs. As the price of labor increases, entrepreneurs will substitute capital and land for labor to the extent that such substitution is feasible in the production function. For example, the automation of many services, such as check-in kiosks at airports and hotels, can substitute capital for labor. Substitution can occur for all the productive resources. Perhaps it is most visible in the substitution that takes place among land, labor, and capital in urban versus rural areas. In urban areas, where land is expen- sive, labor and capital are substituted for land. High-rise structures, which use much more labor and capital, are built. In rural areas, low-rise office buildings and housing units are con- structed. They use far less labor and capital than the high-rise structures of the central city.

Consider what happens when the wage rate falls. To the extent that labor can be substituted for other inputs, more labor will be hired. The greater the degree of substitutability in pro- duction, the greater will be the price elasticity of the demand for labor.

Economics in Action: Dreamers Defend DACA Program

The battle over the DACA program intensified in 2018. Lawyers for both sides argued before the Ninth Circuit Court of Appeals in Pasadena, California. Watch the Trump administration try to justify ending DACA while lawyers for the Dreamers make their case for why it should stay: https://youtu.be/f TL_DwcLskw.

Economics in Action: The Rise of the Machines: Why Automation Is Different This Time

Over the past decades, computers have substituted for a number of jobs, including the functions of bookkeepers, cashiers, and telephone operators. A 2013 study found that about 47% of total U.S. employment is at risk of being replaced by computerization in the next 2 decades (Frey & Osborne, 2013). Automation itself is not new, so why is it different this time? Watch the animated video here: https://youtu.be/WSKi8HfcxEk.

Shifts in the Demand for Labor The demand curve for labor, like the demand curve for products, can shift in response to changes in underlying conditions. Two of the most important causes of such shifts are changes in demand for the product and changes in the employment of the other productive resources.

https://youtu.be/fTL_DwcLskw

https://youtu.be/WSKi8HfcxEk

270

Section 12.5 Productivity and Earnings Differences

Changes in the Demand for the Product The demand for labor is derived from the demand for the product it is used to produce. Sup- pose there is an increase in demand in the product market. The market demand curve will shift to the right. This shift will cause the product price to increase for the competitive firm, because the value of the marginal product of labor will be larger at all levels of production.

In a competitive labor market, each kind of firm will want to hire more labor at the existing wage rate. The market demand for labor could increase, raising both the level of employment and the wage rate. The amount by which the market wage increases will depend on how large the industry is relative to the labor market. If the industry is small, there may be only a very slight increase in wages. If it is large, however, the wage rate could rise significantly.

The Effect of Changes in Other Inputs A second important cause of shifts in the demand for labor results from the fact that the demands for different inputs are mutually interdependent. Suppose the firm doubles the amount of its capital—for example, when a popular restaurant opens a second location. If labor and capital used together are complementary in the sense that an increase in capital makes labor more productive, each unit of labor will have a larger product. Complementarity is a fairly general phenomenon, especially for firms that increase the size of their operations.

Increased productivity resulting from an increased capital stock can have several effects. Con- sider what happens if the capital stock expands in one firm but not the whole industry. The firm’s demand curve (MRPL) would shift to the right in Figures 12.4 and 12.6 without any (noticeable) effect on the market demand curve, because the firm is very small relative to the industry. The result would be that the firm would employ more units of labor at the market- determined price.

On the other hand, consider the effect of an industrywide increase in the capital stock. All firms in the industry have an increase in capital, causing their individual MRPL curves and the industry MRPL curve to shift outward. More labor is employed at a higher wage rate. The market wage would rise as a result.

12.5 Productivity and Earnings Differences Thus far, we have applied marginal productivity theory to labor markets. We have shown that labor becomes more productive and wages rise when the labor is used with more capital. The notion of capital is, however, broader than simply tools. Capital is anything used to increase the flow of output. For example, economists define human capital as anything—such as health, vigor, education, or training—that (a) can be enhanced by “investment” and (b) increases the productivity of the individual.

Just as a firm can increase its investment in capital, an individual can invest in human capital. An individual’s decision to seek additional education is similar to an entrepreneur’s deci- sion to purchase a new piece of equipment. In both cases, the investment is productive if the return (properly discounted) exceeds the cost (properly discounted).

271

Section 12.5 Productivity and Earnings Differences

Higher Education as an Investment Your decision to pursue higher education is a form of investment. The costs are the direct costs (tuition, fees, books, and so on) plus the opportunity costs, primarily lost income (which you could earn instead of going to college). The return is the present value of the increased future earnings caused by the investment in education, as shown in Figure 12.7. Education helps people do higher skilled work, get jobs with better paying companies, or open new businesses.

Figure 12.7: The value of investments in education

Over a lifetime, the average college graduate earns roughly $570,000 more than the average person with a high school diploma only—a large return relative to the up-front investment, which averages $102,000.

“Figure: The value of educational investments,” from “Where is the best place to invest $102,000—In stocks, bonds, or a college degree?,” by M. Greenstone and A. Looney, 2011, Retrieved from https://www.brookings.edu/research/where-is-the-best-place-to-invest-102000 -in-stocks-bonds-or-a-college-degree/

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

$1,000,000

$1,100,000

Less than high school

Note: Figure presents the net present value of earnings of workers from age 22–64 using a 5% discount rate. Sample includes all civilian, U.S. citizens, exluding those in school. Annual earnings are averaged over the entire population, including those without work. Source: March CPS 2007–2010

High school diploma Associate’s degree Bachelor’s degree

The anticipated future wage rate will have a profound impact on the type and amount of education that is pursued. For example, if wages of accountants rise relative to those of engi- neers, economists would expect more students to study accounting. Wages in professions that require long periods of study will have to be higher to attract new entrants, for three rea- sons. First, those in school for long periods of time (like medical doctors) incur greater cur- rent costs. Second, they sacrifice a great deal of present income. Third, their future income is a longer way off. Income received far into the future is worth a great deal less than income now.

https://www.brookings.edu/research/where-is-the-best-place-to-invest-102000-in-stocks-bonds-or-a-college-degree/

272

Section 12.5 Productivity and Earnings Differences

This analysis does not deny that people attend universities and colleges for other reasons besides the return to investment in human capital. Some engage in education for its consump- tion value. For example, retired people returning to school may not be investing in human capital, because their careers have ended. Instead, they are acquiring education for its con- sumption value. There are many consumption-related benefits to education, ranging from enjoyment of literature and fine arts to the thrill of solving a tricky problem in logic. There are also many consumption benefits related to being a student. If you are a member of a uni- versity club or intermural team, you are familiar with some of these consumption benefits.

Not everyone makes career decisions on a strictly economic basis, and we don’t want to imply that you should. You are going to spend the rest of your life working. Why not pick out an occupation or profession that you find enjoyable? This discussion of human capital and edu- cation is similar to many policy debates in economics. An economic model of human capital formation may seem dehumanizing, but you shouldn’t view it that way. It is just another way of analyzing a complex process, and it will give you important insights. These insights can help explain why workers enjoy different income levels or why two workers in the same occu- pation working for the same firm may receive different salaries.

Union Participation One predictor of earnings differences across individuals could be participation in a labor union. A labor union is an organization of workers formed for the purpose of advancing its members’ interests in respect to wages, benefits, and working conditions. According to the American Federation of Labor and Congress of Industrial Organizations (2018), union mem- bers work together to negotiate and enforce a contract with management that guarantees the things you care about like decent raises, affordable health care, job security, and a stable schedule. Labor unions first appeared in the United States in the late 1700s and early 1800s as a protest to wage reductions and poor working conditions. The Federal Society of Journey- men Cordwainers (shoemakers) in 1794 served as the beginning of sustained trade union organization among workers.

Unions allow workers to bargain collectively, which helps shifts the balance of power between the employers and employees in a given industry. In 2017 union members had median usual weekly earnings of $1,041, while nonunion workers had median weekly earnings of $829 (Bureau of Labor Statistics, 2018c). According to the Bureau of Labor Statistics, the union membership rate of public sector workers (34.4%) continued to be more than 5 times higher than that of private sector workers (6.5%). Men continued to have a higher union member- ship rate (11.4%) than women (10.0%), and Black workers remained more likely to be union members than White, Asian, or Hispanic workers.

However, participation in labor unions has decreased in the United States. In 1983, 20.1% of workers were members of a union. By 2017 only 10.7% of wage and salary workers were members of unions. Among states, New York continued to have the highest union member- ship rate (23.8%), while South Carolina continued to have the lowest (2.6%) (Bureau of Labor Statistics, 2018c). As participation in labor unions have fallen, wages have stagnated, possibly as a result of a reduced ability of workers to collectively bargain.

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Section 12.5 Productivity and Earnings Differences

Marginal Productivity and Income The analysis in this chapter leads to an important conclusion of marginal productivity theory. In a competitive labor market, the interaction of the value of the marginal product of labor and the supply of labor determines the wage rate. In turn, the productivity of labor depends on the inherent qualities of the labor, the quantity of labor employed, and the amounts of the other inputs that are used. In other words, the distribution of income is determined by the relative marginal revenue products of the different productive resources. Since wages make up the incomes of laborers, more productive workers will have higher incomes. Laborers who are less productive will have lower incomes.

Economics in Action: What Happened to the American Labor Union?

America’s changing economy might have something to do with it. Labor unions were a prominent part of 20th-century America. But in 2017 only 10.7% of American workers were members of unions, according to the Bureau of Labor Statistics (2018c). What happened to unions, and why are they a diminishing part of working life? Learn here: https://youtu.be/pb-8pxjGcTg.

Global Outlook: Labor Unions Around the World

The United States is not the only country to observe a declining trend in union participation. In 1985, 30% of workers in Organisation for Economic Co-operation and Development (OECD) countries were labor union members, and that has now fallen to just 17%. In many countries, the share of workers covered by collective agreements is significantly higher than the share of workers who are a member of a trade union. The share of workers covered by collective agreements has also contracted in a similar manner to labor union membership, falling from 45% in 1985 to 33% in 2015.

According to the OECD, collective bargaining is high and stable only in countries where multi- employer agreements (sector or national level) are negotiated and where the share of firms that are members of an employer association is high. Perhaps not surprisingly, one important element is the willingness of employers to negotiate.

Even across countries, membership in unions, referred to as labor union density, may vary considerably. In Iceland, for example, half of the country’s workforce is a member of the Icelandic Confederation of Labour (McCarthy, 2017). The difference in union participation is also correlated with the trust that citizens have in unions. For example, in 2010, 40% of respondents to a global survey declared that they trust trade unions, compared with 25% of respondents in specifically the United States and Mexico (OECD, 2017).

If globalization or other structural factors in developed countries are making it more challenging for workers to organize in today’s labor markets, unions will have to find new value propositions to entice workers to organize and join. However, another challenge will be incentivizing workers with benefits other than strictly higher wages, if domestic companies wish to remain globally competitive.

https://youtu.be/pb-8pxjGcTg

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Conclusion

However, the marginal productivity theory says nothing about whether the income distribu- tion that results is a good one. Rather, the theory indicates that if labor markets are competi- tive, each worker will receive returns based on individual productivity. If people don’t like the outcome, they can work to change it through political action (a topic that will be discussed in Chapter 14). The theory also indicates that output will be maximized in societies in which labor is paid according to its marginal productivity.

Conclusion Having learned about the labor demand curve, the labor supply curve, and the resting changes in wages that occur when these curves shift, it should now be more clear why reduced immigration into California led to rising wages in the agricultural industry. It should also now be clear why farmers would shift their production techniques and, more impor- tantly, harvesting practices to reduce their reliance on farm labor.

However, what will become of agriculture in California as a result? First, some crops, like asparagus, will likely no longer be produced in the state. Production of asparagus will continue to shift to Mexico, where the lower relative cost of labor will make production profitable. Farmers will also be shifting to more automated and mechanized processes, like robotic harvesting machines. Ag-tech in the form of reengineered crops will also become more common, such as developing tough-skinned Roma tomatoes that can tolerate mechani- cal harvesting.

In whichever ways that farmers evolve to remain competitive in the $47 billion agricultural industry, it seems apparent that “California agriculture just isn’t going to look the same” (as cited in Mohan, 2017, para. 6), according to Ed Taylor, a University of California–Davis rural economist. “You’re going to be hard-pressed to find crops grown as labor-intensively as they are now.”

Key Ideas

1. A firm is a supplier in the product market and a demander in the resource market. The demand for labor differs from the demand for a product, in that it is derived, interdependent, and technologically determined. The demand for labor is derived from the demand for the product it produces. The amount of labor a firm demands depends on the amounts of land, capital, and enterprise that will be used in com- bination with the labor. And lastly, the demand for labor depends on techniques of production and on technological progress, or the production function.

2. A firm demands labor because labor is productive. The marginal revenue product of labor (MRPL) curve is the firm’s demand curve for labor. A profit-maximizing firm will employ or purchase labor until MRPL = W*.

3. A firm that is a monopolist in a product market uses less labor than a competitive firm would use, because the firm restricts inputs in the process of restricting out- put. The monopolist has to pay the market wage just like any other employer in this market. Because MRPL is less than VMPL, the monopolist does employ fewer workers than similar competitive firms would employ.

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Conclusion

4. The elasticity of the demand for the product that labor produces, the share of the total cost of production that labor represents, and opportunity for input substitu- tion all impact on the elasticity of demand for labor. Shifts in demand for a product will cause shifts in the demand for the labor used to produce that product. Also, increased usage of complementary inputs will raise the marginal revenue product of labor and cause the demand curve to shift outward.

Critical-Thinking Questions

1. How does an entrepreneur decide how much labor to employ? 2. How is a change in the quantity of labor demanded different from a change in the

demand for labor? 3. Name three reasons a firm’s demand for labor would increase. How would this

increase in demand impact the relative wages of the firm’s employees? 4. How does the value of the marginal product of labor differ when there is monopoly

power in the product market? 5. What is a backward-bending supply curve, and what determines where the bend

occurs? 6. The demand for nurses has increased significantly over the past 2 decades, as well as

the salaries for nurses. Is the demand for nurses a derived demand? If so, from what? 7. Describe your decision to take this course in human capital terms. What are

your opportunity costs? Are you planning to make any additional human capital investments?

8. How can the elasticity of demand for the product that labor is producing affect the elasticity of demand for that labor?

9. If an entrepreneur understands the possibility of a backward-bending supply curve, how might that affect the decisions he or she makes about giving employees raises?

10. How does immigration impact the elasticity of supply of labor for each skill level? How would this likely impact wage rates?

11. How could the potential for career interruptions have an impact on starting salaries and create a difference between men and women’s salaries? What could the govern- ment do to counteract this issue?

12. The existence of players’ unions in professional sports is well known. What benefits do the players receive from joining a union? What are the potential costs in the short run and the long run?

13. Why might custodial staff earn higher wages than administrative assistants, even though the assistants could likely perform the functions of the custodial staff ?

14. In which market environments is labor more likely to be exploited? How can the government legislate to help workers in these markets?

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Conclusion

Key Terms backward-bending supply curve A labor supply curve that slopes back to the left at the point where the income effect dominates the substitution effect.

derived demand Demand for a productive resource that results from demand for a final good or service. For example, the demand for labor is derived from the demand for the product that the labor produces.

interdependent demand Demand that depends on another type of demand. For example, a firm’s demand for labor depends on the amount of other resources that the firm plans to use.

labor union An organization of workers formed for the purpose of advancing its members’ interests in respect to wages, ben- efits, and working conditions.

marginal productivity theory An expla- nation of how the distribution of income is determined in a market system. Each input is paid according to its contribution, or its marginal productivity.

marginal revenue product of labor (MRPL) The amount that an additional unit of labor adds to a firm’s total revenue.

technologically determined demand Demand that depends on techniques of production and technological progress. For example, the demand for labor will be affected by the introductions of new technol- ogy in a firm or industry.

value of the marginal product of labor (VMPL) A measure of the value of the addi- tional output that each unit of additional labor adds to a firm’s total, found by multi- plying the marginal product by the price at which the firm can sell the product.