Labor Economics

The fundamental dynamics of supply and demand apply as much to labor as they do to markets for goods and services. Unemployment, the bane of white and blue collar workers alike, occurs whenever there are more people seeking a particular job than there are employers looking to fill such positions. Thus, unemployment is a constant that varies only in degree and kind. How employers determine the number of workers they require at any given time and the number of hours workers are willing to spend on the job at a given wage- rate are both micro-economically quantifiable. No less important (but harder to precisely pin down) is the microeconomic impact of unemployment. Consumer spending accounts for almost two thirds of all purchases in developed economies, and the vast majority of consumers here are wage earners. So, higher unemployment rates slow or cause negative economic growth that can lead to more lay-offs.

Keywords Collective Bargaining; Frictional Unemployment; Full Employment; Human Capital; Law of Diminishing Returns; Marginal Physical Product of Labor; Marginal Resource Cost of Labor; Monopoly; Oligopoly; Opportunity Cost; Structural Unemployment; Substitution Effect; Utility Function; Utility-Maximizing Behavior; Wage Elasticity

Economics > Labor Economics

Overview

All wealth stems from a nation's productive capacity; the harnessing of land, raw materials, capital and labor for the express purpose of creating saleable goods and services. Collectively, the earnings garnered through labor amount to some three-quarters of an industrially-developed country's total national income. Consequently, the earnings fund much of the consumer spending that typically makes up some two-thirds of a country's overall economic activity. No wonder, then, that public anxiety quickly mounts when the national unemployment figure exceeds a certain level and why the goal of government economic policy is full employment. The more people working, essentially, the more money they have to spend on discretionary items like electronics, cosmetics, etc. This increased demand leads suppliers to ramp up production and eventually hire additional workers. Alas, the converse also holds true: If demand for too many goods drops appreciably, producers lay-off workers. And their subsequent belt-tightening causes demand to drop further, triggering more lay-offs and even sharper drops.

Even the most penny-pinching industrialist has a long-term vested-interest in paying more than a subsistence wage. But exactly how much should a given employer pay its hourly workers? When exactly should it hire or lay-off additional ones? Can a firm maximize its profits and compensate its workers with a fair and living wage or are the two objectives in the final analysis incompatible? And what about the worker: Does he or she economically benefit from many years of schooling or from joining a union? Questions like these are the focus of inquiry in labor economics, a field that draws heavily on the microeconomic principles of supply and demand (Cleaver, 2002). Laborers basically sell services that employers are willing to buy. The greater the demand for a particular service, the higher the price or wage. However, this is not true past a certain point, as few producers can afford to pay out more in costs than they earn in sales revenue for very long. This very real constraint tempers union demands made of employers during contract negotiations. Employers face the countervailing constraint of a strike; a strong union can leverage its sole supplier status to its advantage just like a business monopoly can.

Applications

Microeconomic theory presupposes perfect competition and perfect information — ideal conditions that rarely (if ever) occur in real-world markets. Competition is said to be perfect when every market participant can enter and exist at will and none face outside restraints on how they conduct their business. Similarly, information is said to be perfect when every participant knows the range of prices on offer for a good or service it supplies and the identity of all of its competitors. Much is gained, though, by suspending disbelief and buying into this simplified model, for several of its fundamental concepts and principles can now be applied to very good effect. Indeed, market equilibrium, marginal analysis, opportunity costs, price elasticity, the utility function, and the substitution effect as we are about to see add to and deepen our understanding of how labor markets function.

Supply of Labor

The labor force is made up every one either employed or seeking employment. Children and the stay-at-home parents who care for them are excluded, as are the institutionalized. Market-wise, moreover, atypical constraints are built into the labor force: Namely, that there is an upward limit to the number of employable people at any given time and not one of them is capable, much less willing to work twenty four hours a day. In fact, in developed countries, in-kind payments by governments to the indigent and unemployed effectively eliminate the threat of starvation; not necessarily everyone has to work and earn his or her keep. In industrialized nations, then, the particular utility function of the individual, the sum of goods, services and activities that satisfies him or her, causes people to seek work. That, after all, is what economists expect any rational person to do. An individual exhibits utility-maximizing behavior whenever he or she both works and regularly enjoys a certain amount of leisure time.

Marginal Utility of the Individual

But no two people are exactly alike. Some enjoy material goods more than others and are willing to work longer hours to afford them. Conversely, some enjoy leisure for leisure's sake more and are not willing to work longer hours. When plotted on a graph, the line connecting different degree-points of preference for income measured in hours work versus leisure curves up and inwards to a point, then outwards again above that point. Apparently, people are prepared to sacrifice only so much leisure time to earn added income and vice-versa; only so much income to enjoy added leisure time. The point where leisure time and income converge is referred to as an individual's marginal utility. Of course, the availability of work affects both decisions as Larson (1981) documents; people simply have less choice overall during periods of recession. During periods of economic growth, by contrast, employers come under increasing pressure to raise wages. If they do not, workers will migrate to employers who do. Higher production volumes presumably generate greater profits for the company as well as more work for employees, so the latter feel they truly deserve a raise.

The often unasked question for both then becomes: How will a wage increase affect the existing range of employee preferences for work over leisure? Having more money to spend, after all, enhances one's utility function; by rights, then, the balance should either tip more towards leisure or remain largely unchanged, shouldn't it? Actually, as it turns out, the preference shifts decidedly towards working more hours to earn a higher income. As workers factor in the higher wage, the prospect of missing out on the chance to earn more by pursuing leisure activities instead is simply too onerous. The opportunity cost in potential wages lost by not working additional hours here supersedes the more intrinsic value the employee assigns to leisure activities. And thanks to labor economists, employers know all about this seemingly paradoxical effect. Indeed, they have determined that the cost of hiring new workers exceeds the cost of a raise and wisely opt for the latter.

Price Elasticity of Supply

The preceding example illustrates how the price elasticity of supply can trigger the substitution effect. A higher price (wage per hour) in this instance resulted in a greater number of units of output (hours of labor) from existing employees willing to forgo leisure time. An actual value can be calculated for this index by dividing the percent change in output by the percent change in price. Just how elastic this supply is, though, differs in the short and the long run. Generally speaking, the farther out the time horizon, the greater the amount of production capacity on stream, the more the number of established providers and the greater the likelihood of available product substitutes. Labor's elasticity of supply tends to be more elastic in the long-run for skilled workers but not for unskilled ones (Acemoglu, 2001). It takes much time to train and season skilled workers. Barring their migration from other locales, demand will likely exceed supply, necessitating higher wages that will attract enough trainees eventually to reestablish market equilibrium. Unskilled laborers, on the other hand, are always available and require little or no training, so the price-supply relationship here is much more inelastic and wages rise slowly if at all.

Waste Elasticity

Wage elasticity, what's more, tends to be higher in industries and markets where there are an ample number of competitors. The more firms vying to hire workers, in fact, the more 'perfectly' elastic the wage rate becomes; the fewer the more inelastic. In the extreme case where a monopoly controls an entire market, one company effectively sets the going price for a good or service by deliberately limiting its production volume. Given the lack of alternative employers, workers are reduced to the status of price-takers when it comes to wages and hours. They can and do resort to form unions to gain bargaining power; challenging one monopoly by banding together to create another (Moroney & Allen, 1969). In oligopolies, workers can at least seek alternate employment at two or three other major competitors and thus theoretically enjoy greater price elasticity in their wage package. Oligopolies are creatures of maturing markets, however, where profits come as much if not more from cost-containment as from sales growth. Firms also leverage economies-of-scale wherever and whenever possible, and substitute technology for labor to further trim costs. Realistically, these combined factors tend to lessen such elasticity.

Demand for Labor

Both skilled and unskilled laborers have jobs to begin with because the firms that employ them earn enough income from sales in the long-term to stay in business. But as any business person can tell you, sales fluctuate from year to year. And so, invariably, does production, necessitating adjustments in the size of a firm's workforce. Demand for labor is thus said to be a derived demand, so every firm periodically adjusts its labor requirements to respond to changing market conditions using a series of calculations to arrive at an exact figure. A firm must first determine the wage rate it is prepared to pay. Knowing this allows it to come up with a rough approximation of its labor needs since every job market has a supply curve.

Marginal Physical Product of Labor

While approximations can be helpful, a firm's interests are better served by coming up with an exact figure. This can be done by calculating the Marginal Physical Product of Labor; the number of additional units of output one extra worker produces. When multiplied by the selling price of a unit, an employer can ascertain the unit's Value of Marginal Physical Product of Labor, which in competitive markets equals the Marginal Revenue Product of Labor, or, the total revenue earned when the output of one additional worker is sold. A firm maximizes its profits when its marginal cost, the added expense incurred to produce one more unit of output, equals its marginal revenue. By extension, then, the maximum amount of labor needed lies at the point where a firm's Marginal Resource Cost of Labor, the additional cost incurred to hire one more worker, equals its Marginal Revenue Product.

Law of Diminishing Returns

Employers who disregard this seemingly arcane calculation end up regretting their decision. Curiously, though, more problems arise when employers hire too many new workers as opposed to too few. This can be explained by the Law of Diminishing Returns which states that steadily increasing one variable factor of production while holding the others constant will eventually cause a decline in productivity. When that variable is labor and there isn't a corresponding increase in equipment and plant, overcrowding on the factory floor can begin to take its toll on production. Thereafter, the amount of additional output the latest new hire produces will be less than the amount the preceding new hire produces.

Unemployment

The term 'unemployment' evokes all sorts of dire connotations. Anyone who has experienced it knows why. Economically-speaking, though, it's a constant and considered as inevitable as a naturally-occurring phenomenon. As odd as this sounds, unemployment even exists in times of "full-employment" when, theoretically, everyone who can work has a job that makes the most efficient use of his or her skills. This is because information regarding job availability is never "perfect." It takes time to find openings, be interviewed and the like. Job-seekers, as economists are fond of saying, incur transaction costs. But they have every expectation of finding work and usually do in time. This kind unemployment is thus relatively benign and so much a part of economic life that it is dubbed "fictional." People are constantly entering the work force for the first time, re-entering it after retraining or raising a child, or else simply keen to find a better job.

Structural Unemployment

"Structural" unemployment is another matter all together. Essentially there are far more workers looking for employment in a particular occupation or industry than there are openings for them (Wood, 1988). Sometimes a major shock to the economic system as a whole is to blame. Over time there's usually a rebound and a return to previous levels of employment, so the dislocation is not permanent. More often, though, it is because an irreversible shift has occurred either in derived demand or in the production process. The goods and services workers once produced have either fallen out-of-favor, been replaced by substitutes or their jobs are now done better, faster and cheaper by technology. Laid-off workers with skills not easily transferable to other industries face bleak economic futures only partly ameliorated by unemployment benefits, welfare and other in-kind government payments. Indeed, unless they are willing to invest time, effort and money in learning a more marketable skill of equal value, the earning power of these displaced workers will never be as great again. Herein lies one major reason why the idea of human capital has gained so many adherents.

Human Capital

The 'post-industrial' age, the 'knowledge' economy and other familiar buzz words underscore the importance put these days on 'human' capital. But what exactly does the term mean? In theory and practice the idea of human capital revolves around one central idea: The more skills a worker accrues the more his or her value to employers and the greater his or her earnings potential and long-tem job security (Acemoglu, 1996). Firms here have vested interest in providing training and education that improves the skill-sets of their workers. One benefit of such practices is improved productivity and cost efficiency, both of which increasingly depend upon leveraging technology. Another benefit is worker retention: The higher the employee turnover rate, the higher the transaction costs of hiring replacements and the higher the opportunity costs of failing to keep experienced workers. Individuals, like firms, have a vested interest in improving their skill-sets with or without their company's help. Capitalism, as a famous economist once pointed out, continually engages in a process of 'creative destruction' where the only real constant is change. Increasingly, too, that change is driven by advances in technology that workers must keep abreast of to have 'marketable' skills. Investing in training, education, and the like is thus as important to the individual as investing in mutual funds to build a retirement nest-egg and to the firm as investing in new equipment and plants.

Unions

Mention of the word 'labor' and most people immediately think 'union.' Unions are formed by and for workers for the express purpose of safeguarding and furthering their members' interests and welfare through collective bargaining and mediation. Their public image as the 'champion' of the worker belies, economically-speaking, how strikingly similar a union's organizational agenda and desired outcomes are to those of a business (Oswald, 1982). Its membership dues in this respect are its sales revenue, its 'product' favorable contract terms for its rank-and-file, and its overriding strategic consideration for its own survival and growth. Contrary to its 'militant' roots, today's union typically resorts to confrontational tactics only when compromise and cooperation fails. And it will more than likely tone down its rhetoric and relent on its threats of work stoppages and strikes the minute management puts an acceptable offer on the table. This is due, in part, to the fact that union leaders are aware that their relationship with company management is ultimately symbiotic. The specter of wholesale lay-offs in the smokestack industries of the U.S. in the 1980s and 1990s and the result of irreversible structural shifts in the economy as a whole have not been forgotten. Nor can it be, for globalization, the root-cause of these shifts, is now an ever-present factor.

Some would go so far as to argue that the union movement in the developed world is in decline. It certainly has been steadily losing membership and thus bargaining power in the U.S. manufacturing sector over the last four decades. Countervailing organizing efforts in the growing service-industry sector have met with only limited success primarily because the pool of labor drawn on here is unskilled. Greater mobility in the workforce, declining demographics, and automation has all eroded the traditional base of support for unions. In Europe, the traditions of trade union militancy and social democratic politics run deeper and have made the labor movement more resilient. Nonetheless, the industrial workers that once swelled unions' ranks in the developed world are now much more likely to be found in the developing world. And the prevailing political climate and economic development policies there often do not countenance union organizing to any great degree.

Discourse

Labor may not have as high a public profile as it once did. Its importance as a key variable factor of production nonetheless remains undiminished. Labor runs the machines, builds both the components-parts and plant infrastructure instrumental to the production of saleable goods and does the work required to provide marketable services. The earnings workers make, what's more, fuel consumer spending and are thus an integral part of the circular flow of money at the heart of all economic activity. Demand for and supply of labor has been, is and will always be, a central concern of microeconomics.

Terms & Concepts

Collective Bargaining: The negotiations that take place between management and leaders of a labor union over wages and working conditions.

Frictional Unemployment: A type of unemployment temporary in nature where workers are searching for a new job, undergoing training, etc.

Full Employment: The point in a national economy when every available worker, both skilled and unskilled, earns a steady wage from the most productive work they're capable of. What residual unemployment that does exist is entirely frictional in nature.

Human Capital: The economic value of a worker's cumulative training and experience, both of which can be broadened and deepened through an additional investment of time and money, further increasing the worker's value.

Law of Diminishing Returns: Once a certain threshold is reached, the more one variable factor of production like labor is increased, the less additional output it contributes

Marginal Resource Cost of Labor: The extra costs associated with hiring one more worker.

Marginal Physical Product of Labor: The additional output achieved by hiring one more worker.

Monopoly: A market where one and only one producer sells a good or service.

Oligopoly: A market where a just few producers sell a good or service.

Opportunity Cost: The value of a course of action not taken because another course of action is.

Structural Unemployment: Prolonged unemployment caused by underlying shifts in market supply and demand.

Substitution Effect: Where two or more factors of production are more or less interchangeable, a price rise in one triggers its replacement by the other. When the price in question is a wage, laborers reduce their leisure time to work longer hours at the higher rate. Employers, conversely, adapt cost-efficient new technologies or outsource parts of the production process.

Utility-Maximizing Behavior: The assumption made by economists that because people are rational, they will pursue a course of action that best satisfies their needs and interests.

Variable Factor of Production: One of several basic inputs to production — labor, capital, technology, etc. — that can be changed in the short run.

Bibliography

Acemoglu, D. (1996). A microfoundation for social increasing returns in human capital accumulation. Quarterly Journal of Economics, 111, 779-804. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9705282625&site=ehost-live

Acemoglu, D. (2001). Good jobs versus bad jobs. Journal of Labor Economics, 19, 1-22. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4100722&site=ehost-live

Clever, T. (2002). Chapter 3: Microeconomics and macroeconomics. In Understanding the world economy (pp. 53-67). United Kingdom: Taylor & Francis Ltd. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=16867330&site=ehost-live

Dobbs, R., Lund, S., & Madgavkar, A. (2012). Talent tensions ahead: A CEO briefing. Mckinsey Quarterly, , 92-102. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82911531&site=ehost-live

Larson, D. (1981). Labor supply adjustment over the business cycle. Industrial & Labor Relations Review, 34, 591-595. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4476295&site=ehost-live

Mitton, T. (2012). Inefficient labor or inefficient capital? Corporate diversification and productivity around the world. Journal of Financial & Quantitative Analysis, 47, 1-22. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=74405985&site=ehost-live

Moroney, J., & Allen, B. (1969). Monopoly power and relative share of labor. Industrial & Labor Relations Review, 22, 167-178. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4463961&site=ehost-live

Osterman, P. (2011). Institutional labor economics, the new personnel economics, and internal labor markets: a reconsideration. Industrial & Labor Relations Review, 64, 637-653. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=62543129&site=ehost-live

Oswald, A. (1982). The microeconomic theory of the trade union. Economic Journal, 92, 576-595. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4531859&site=ehost-live

Wood, A. (1988). How much unemployment is structural? Oxford Bulletin of Economics & Statistics, 50, 71-81. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5162708&site=ehost-live

Suggested Reading

Baily, M., Bartelsman, E., & Haltiwanger, J. (2001). Labor productivity: Structural change and cyclical dynamics. Review of Economics & Statistics, 83, 420-433. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5324170&site=ehost-live

Brown, A. (1971). Further analysis of the supply of labour to the firm. Journal of Management Studies, 8, 280. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4554497&site=ehost-live

Edwards, E. (1959). Classical and keynesian employment theories: a reconciliation. Quarterly Journal of Economics, 73, 407-428. Retrieved July 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=7696794&site=ehost-live

Gowler, D. (1969). Determinants of the supply of labour to the firm. Journal of Management Studies, 6, 73-96. Retrieved July 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4554414&site=ehost-live