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Chapter 7

The Labor Market,


Wages, and
Unemployment

7.1 Introduction
In this chapter, we learn:
How a basic supply-and-demand model helps
us understand the labor market.

How labor market distortions like taxes and ring


costs affect employment in the long run.

How to compute present discounted values


How to value your human capital.
Why the return to a college education has risen
enormously over the last half-century.
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7.2 The U.S. Labor Market


In the U.S. labor market
Wages account for two-thirds of per capita GDP.
Average wages have grown at 2 percent per year
for the last century.

The employment-population ratio


The fraction of the civilian population over the
age of 16 that is working

This ratio:
Has been increasing over time in large part due
to the entry of women into the workforce.
Decreases in times of a recession.

The unemployment rate


The fraction of the labor force that is
unemployed

A person is unemployed if the following


conditions hold:
She does not have a job that pays a wage or
salary.
She actively looked for a job during the four
weeks before measuring the unemployment
rate.
She is available to work.
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The Dynamics of the Labor


Market

Job creation and job destruction in the United


States
Occur each month
Are part of normal changes in the economy

Unemployment

For most people, periods of unemployment are


relatively short.

People who are unemployed for long periods


account for most of the total weeks of lost work.

Many countries have developed social safety


nets.

7.3 Supply and Demand


The labor demand curve slopes downward
because of diminishing marginal product of
labor (MPL).

The labor supply curve slopes upward because


the price of leisure is higher when wages are
higher.

The intersection of labor supply and demand


determines the level of employment and the
wage rate.
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A Change in Labor Supply

If the government collects a tax on a workers


wage:
The labor supply curve shifts left.
A worker receives less money and supplies
less laborthis applies to any wage.
In order to be in equilibrium, firms must raise
wages.

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A Change in Labor Demand

Suppose the government creates regulations


making it harder to fire workers.
Firms will demand fewer workers.
Labor demand shifts left, causing wages and
employment to fall.
The unemployment rate rises initially and
recovers as discouraged workers drop out of
the labor force.

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Wage Rigidity

Wage rigidity
Wages fail to adjust after a shock to labor
demand or supply.

What happens if wages do not fall in the above


demand shock example?
The labor market will not clear and this results
in a larger fall in employment.

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Case Study: Supply and Demand


Shocks in the U.S. Labor Market

Increase in the employment-population ratio


Due in large part to increases in the number of

women working
Supply shocks
Changes in social norms
Changes in technology for managing fertility
Demand shocks
Reduced discrimination against women
Historically:
Rising unemployment in the 1960s and 1970s
Decline in unemployment in the 1980s
Possibly explained by the baby boom

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Different Kinds of
Unemployment

The natural rate of unemployment


Rate that would prevail if the economy were
in neither a boom nor a bust

Cyclical unemployment
The difference between the actual rate and
the natural rate
Associated with short-run fluctuations in
output

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The natural rate of unemployment includes two


components:
Frictional unemployment:
workers being between jobs in the dynamic
economy
Structural unemployment:
labor market failing to match up workers and
firms in the market

Actual unemployment is the sum of frictional,


structural, and cyclical unemployment.

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7.4 Bathtub Model of


Unemployment
Bathtub model:
Two endogenous variables: employment

E and

unemployment U
Model states how employment and
unemployment evolve over time
Analogy: water entering and draining a bath
tub at the same rate

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Two equations:

employment

change in
unemployment

unemployment
job separation
rate

size of
labor force
job finding
rate

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Solving the model:


Set the change in unemployment to zero

Solve the equation for U

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The unemployment rate is defined as the


fraction of the labor force that is unemployed.
Therefore:

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Insights of the model:


Only way to alter the natural rate of
unemployment is:
change the job finding rate.
change the job separation rate.
Policies along these lines can have
unintended consequences.

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7.5 Labor Markets around the World


Some facts about international labor markets since 1980:
Unemployment in Europe:
Substantially above Americas rate
Unemployment in Japan:
Historically below the United States.

European unemployment has increased dramatically


because of:

Adverse shocks and high oil prices.


Inefficient labor market institutions in the form of higher
unemployment and welfare benefits.

1990s hours worked in Europe much lower than 1970s


levels.

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GDP per capita is lower in Europe. Why?


People work less hours.
If working less is voluntary:
Europeans enjoy leisure more and welfare is
likely improved.

If working less is a result of distortions in the


labor market:
This outcome is likely not welfare enhancing.

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Case Study: Efficiency of Wages and


Henry Fords Five-Dollar-a-Day Plan

Ford instituted a five-dollar-a-day minimum wage.


The theory of efficiency wages:
Recognizes that paying a wage greater than the

wage needed to retain a worker may actually


increase a firms profits.
Paying higher wages
Allows workers to eat healthier and become more
productive.
Increases level of effort
Decreases shirking
Will attract more able workers to a firm.

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7.6 How Much Is Your Human Capital


Worth?

The present discounted value of your


lifetime income is likely greater than $1
million.

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Present Discounted Value

Present discounted value


The value of money you would need to put in
the bank today to equal a given future value.
Tells how much a future payment or a future
flow of payments is worth today.

Equation for present discounted value:

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To calculate the value of a stream of equal


payments over a given number of years:
Arrange the sum of each periods present
discounted values into a geometric series.
Use the formula for a sum of a geometric series
to calculate the present discounted value of the
stream of payments.

If a is some number between 0 and 1, then


calculating a geometric series is:

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For example, the series for a $100 initial


payment for twenty years is:

Or:

From previous page: If a = 1/(1 + R), then:

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Letting the interest rate R = .10


What is the pdv on $100 over 20 years?
$936.

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Your Human Capital


Example: Assume
The average income is $63,000
No wage growth
An interest rate of 3 percent
A lifetime work span of 45 years
The pdv of this stream of payments is 1.59
million dollars.

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7.7 The Rising Return to Education


The premium to having a college degree:
Has been rising rapidly over the last forty
years.
Far outweighs the forgone wages and tuition
costs of going to college.

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As wages have grown, so has the supply of


college graduatesan increase in supply should
cause wages to fall. Why hasnt this happened?

The demand for college-educated workers has


increased by an amount large enough to offset
supply.

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Explanations for a large shift in demand for


highly educated workers include:

Skill-biased technical change: new technologies


are more effective at improving productivity of
college-educated workers.

Globalization: increased opening of trade.

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Case Study: Income Inequality

Rising college premium is one cause of rising


income inequality

Early 1900s
Most inequality associated with capital income
Recently
Most inequality associated with salaries and
business income

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Summary
The labor market is arguably the most important
market in an economy.

The tools of supply and demand allow us to


understand the changes in the labor market that
have occurred in the United States since 1950:
Increase in the employment-population ratio
Rising return to education

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Labor markets are often characterized by:


Large quantities of job creation and job
destruction.
This results in much smaller overall changes in
employment.

In the United States:


Most unemployed workers find new jobs
relatively quickly.
Most unemployment is accounted for by people
out of work for long periods of time.

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Certain factors appear to play important roles in


explaining the relatively high unemployment
rates and low hours worked in Europe.

Examples of factors:
Oil shocks and productivity slowdown of the
1970s
Inefficient labor market institutions

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Because the labor market is so important, problems


like unemployment merit serious responses by
society.

Designing the right safety net requires balancing


the needs for social insurance against the
disincentives associated with the insurance.

Present discounted values help us compare


financial payments received at different times.

We value payments today more than payments


tomorrow.
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The rising return to a college education is one of


the key facts of the labor market.

This college wage premium has risen from about


50 percent in 1963 to about 90 percent by 2005.
Wage differentials between college graduates
and high school graduates has increased.

Possible explanations:
skill-biased technical change
globalization

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