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

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1 Chapter Wage Determination QUESTIONS. Explain why the general level of wages is high in the United States and other industrially advanced countries. What is the single most important factor underlying the long run increase in average real wage rates in the United States? LO Answer: The general level of wages is higher in the United States and other industrially advanced nations because of the high demand for labor in relation to supply. Labor productivity is high in the U.S and other industrially advanced countries because: () capital per worker is very high; () natural resources are abundant relative to the size of the labor force particularly in the U.S.; () technology is advanced in the United States and other industrially advanced countries relative to much of the rest of the world; (4) labor quality is high because of health, vigor, training, and work attitudes; () other factors contributing to high American productivity are the efficiency and flexibility of American management; the business, social, and political environment that greatly emphasizes production and productivity; and the vast domestic market, which facilitates the gaining of economies of scale.. Why is a firm in a purely competitive labor market a wage taker? What would happen if it decided to pay less than the going market wage rate? LO Answer: A firm in a purely competitive labor market is a wage taker because there are a large number of firms wanting to buy the labor services of the workers in that market and a large number of workers with identical skills wanting to sell their labor services. As a result, the individual firm has no control over the price of labor. If a firm attempted to pay a wage below the going wage, no workers would offer their services to that firm.. Describe wage determination in a labor market in which workers are unorganized and many firms actively compete for the services of labor. Show this situation graphically, using W to indicate the equilibrium wage rate and Q to show the number of workers hired by the firms as a group. Show the labor supply curve of the individual firm, and compare it with that of the total market. Why the differences? In the diagram representing the firm, identify total revenue, total wage cost, and revenue available for the payment of non-labor resources. LO Answer: The labor market is made up of many firms desiring to purchase a particular labor service and of many workers with that labor service. The market demand curve is downward sloping because of diminishing returns and the market supply curve is upward sloping because a higher wage will be necessary to attract additional workers into the market. Whereas the individual firm s supply curve is perfectly elastic because it can hire any number of workers at the going wage, the market supply curve is upward sloping. For the graphs, see Figure. and its legend. -

2 4. Suppose the formerly competing firms in question form an employers association that hires labor as a monopsonist would. Describe verbally the effect on wage rates and employment. Adjust the graph you drew for question, showing the monopsonistic wage rate and employment level as W and Q, respectively. Using this monopsony model, explain why hospital administrators sometimes complain about a shortage of nurses. How might such a shortage be corrected? LO Answer: The equilibrium wage in the monopsonistic market declines from the competitive market s W l rate to W. The employment level in this market will decline from Q to Q. See Figure.4 (wage falls from W c to W m and the employment level falls from Q c to Q m). If there are only one or two hospitals in an area, there exists a monopsonistic market for nurses. Their wages would be less than those for nurses where there is competition among employers (numerous hospitals and/or clinics). Because hospitals prefer to hire more nurses at a wage W, they view the difference between Q and Q as a shortage. However, since their profits are maximized at W, they are unwilling to raise wages voluntarily. The hospital administrator might offer a higher wage, but this wage would not be profit maximizing. Another solution would be for nurses to organize and demand higher wages. This would allow nurses to earn wages closer to their MRP and as wages rise toward W, the shortage would disappear.. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as indicated in Figure.8. Now suppose an industrial union is formed that forces the employer to accept a wage rate of Wc. Explain verbally and graphically why in this instance the higher wage rate will be accompanied by an increase in the number of workers hired. LO4 Answer: The union wage rate Wc becomes the firm s MRC, which would be shown as a horizontal line to the left of the labor supply curve. Each unit of labor now adds only its own wage rate to the firm s costs. The firm will employ Q c workers, the quantity of labor where MRP = MRC (= W c ); Qc is greater than the Q m workers it would employ if there were no union and if the employer did not have any monopsonistic power, i.e., more workers are will to offer their labor services when the wage is Wc than Wm.. Have you ever worked for the minimum wage? If so, for how long? Would you favor increasing the minimum wage by a dollar? By two dollars? By five dollars? Explain your reasoning. LO Answer: Student answers will vary. Those students that have worked for minimum wage probably didn t stay at that job for long, and would probably describe their performance and that of their co-workers as relatively unproductive (an absence of efficiency wages). Support for an increase will depend on factors such as their perception of how much employment would be lost versus the income gains of those retaining employment. -

3 7. Many of the lowest paid people in society for example, short order cooks also have relatively poor working conditions. Hence, the notion of compensating wage differentials is disproved. Do you agree? Explain. LO Answer: Short-order cooks generally need few specific skills, i.e., practically anyone is thought to be capable of flipping burgers. Since the supply of unskilled workers is high relative to the demand for them, their wages are low. In this case, the concept of compensating wage differentials is swamped by the excess supply of low-wage workers. 8. What is meant by investment in human capital? Use this concept to explain (a) wage differentials and (b) the long run rise of real wage rates in the United States. LO Answer: Investment in human capital is educational activity that improves individual productivity (a) Wage differentials are explainable to some extent through the concept of human capital investment. There is a strong positive correlation between time spent acquiring a formal education and lifetime earnings. Of course, it can be said that the brain surgeon who spent over twenty years in training, starting in grade, had the qualities to succeed in the labor market without spending over twenty years in school. Though this counter-argument has some merit, the point still is that this highlyskilled individual would never have become a brain surgeon without the over twenty years in school and might not have achieved the particular high income that goes with being a medical specialist. (b) The long-run rise in real wage rates in the United States is positively correlated to investment in human capital. Without the increase in education and training of the American labor force that has occurred over the years, productivity (output per person per hour) would still have risen because of the investment in real capital, improved technology, and our abundant natural resource base. But the real wage would undoubtedly now be very much lower, because an unskilled labor force could not possibly have made efficient use of the material resources and advancing technology of the economy. 9. What is the principal agent problem? Have you ever worked in a setting where this problem has arisen? If so, do you think increased monitoring would have eliminated the problem? Why don t firms simply hire more supervisors to eliminate shirking? LO Answer: Business owners who hire workers because they are needed to help produce the goods or services of the firm face the dilemma of the principal-agent problem. Workers are the agents; they are hired to promote the interests of the firm's owners (the principals). Owners and workers both have a common goal in the survival of the firm, but their interests are not identical. A principal- agent problem arises when those interests diverge. Workers may seek to increase their utility by shirking their responsibilities and providing less than the agreed upon effort. Owners of firms have a profit incentive to reduce or eliminate shirking. Hiring more supervisory personnel can be costly and there is no guarantee that it will eliminate the problem. -

4 . LAST WORD Do you think exceptionally high pay to CEOs is economically justified? Why or why not? Answer: Student answers will vary. Supporters will point to the important decisions made by CEOs and their effect on overall firm productivity. High pay provides an incentive not only for current CEOs, but also for aspiring CEOs, further enhancing productivity. Critics argue that while pay gaps are necessary, they are excessive relative to the productivity differences. They further argue that stockholders are hurt because high CEO pay reduces company profits. PROBLEMS. Workers are compensated by firms with benefits in addition to wages and salaries. The most prominent benefit offered by many firms is health insurance. Suppose that in workers at one steel plant were paid $ per hour and in addition received health benefits at the rate of $4 per hour. Also suppose that by workers at that plant were paid $ per hour but received $9 in health insurance benefits. LO a. By what percentage did total compensation (wages plus benefits) change at this plant from to? What was the approximate average annual percentage change in total compensation? b. By what percentage did wages change at this plant from to? What was the approximate average annual percentage change in wages? c. If workers value a dollar of health benefits as much as they value a dollar of wages, by what total percentage will they feel that their incomes have risen over this time period? What if they only consider wages when calculating their incomes? d. Is it possible for workers to feel as though their wages are stagnating even if total compensation is rising? Answers: (a) compensation rose from $4 in to $ in. This is a % increase. Dividing that number by we see that the average annual growth rate was approximately.% per year. (b) Wages went up by % over this time period (= $/$). Dividing that number by the number of years (), we see that the approximate average annual growth rate of total compensation was.% per year. (c) If workers value health benefits as much as wages, then they will feel that their incomes have risen by %. If they exclude health benefits and focus only on wages, they will feel that their incomes went up %. (d) Yes, this is possible. See answers to part c. Feedback: Consider the following example: Suppose that in workers at one steel plant were paid $ per hour and in addition received health benefits at the rate of $4 per hour. Also suppose that by workers at that plant were paid $ per hour but received $9 in health insurance benefits. Part a: compensation in was $4 (=$ (wage rate) + $4 (health benefits)) and in total compensation is $ (=$ + $9). The percentage increase in total compensation is (-4)/4 = /4 =. (or %). This implies the approximate average annual percentage change in total compensation is./ =. (or.%). -4

5 Part b: The percentage increase in wages alone is (-)/ = / =. (or %). This implies the approximate average annual percentage change in wages is./ =. (or.%). Part c: If workers value a dollar of health benefits as much as they value a dollar of wages, they feel that their incomes have risen by % (part a) over this time period. If they only consider wages when calculating their incomes they feel that their incomes have risen by % (part b) over this time period. Part d: Yes, if workers only look at their wages they may feel as if their wages are stagnating.. Complete the following labor supply table for a firm hiring labor competitively: LO a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Are the curves the same or different? If they are different, which one is higher? b. Plot the labor demand data of question in Chapter on the graph used in part a above. What are the equilibrium wage rate and level of employment? Answers: (a) The supply curve and the MRC are the same. Units of labor Wage Rate labor cost resource (labor) cost 4 $ $ $ -

6 (b) Equilibrium wage rate = $; equilibrium level of employment = units of labor. Feedback: Consider the following example (Table): -

7 (a) The labor supply curve and MRC curve coincide as a single horizontal line at the market wage rate of $. The firm can employ as much labor as it wants, each unit costing $; wage rate = MRC because the wage rate is constant to the firm. Units of labor Wage Rate labor cost resource (labor) cost 4 $ $ $ (b) Graph: equilibrium is at the intersection of the MRP and MRC curves. Equilibrium wage rate = $; equilibrium level of employment = units of labor. From the tables: MRP exceeds MRC for each of the first four units of labor, but MRP is less than MRC for the fifth unit. Table from question, Chapter : -7

8 Units of labor product product Product price revenue revenue product $ $ 4 8 $ Assume a firm is a monopsonist that can hire its first worker for $ but must increase the wage rate by $ to attract each successive worker (so that the second worker must be paid $9, the third $, and so on). LO a. Draw the firm s labor supply and marginal resource cost curves. Are the curves the same or different? If they are different, which one is higher? b. On the same graph, plot the labor demand data of question in Chapter. What are the equilibrium wage rate and level of employment? c. Compare these answers with those you found in problem. By how much does the monoposonist reduce wages below the competitive wage? By how much does the monopsonist reduce employment below the competitive level? Answers: (a) Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)): -8

9 MRC monopsony MRP = $4 MRC = $8 competitive wage = $ Supply monopsony MRC=Supply competitive monopsony wage = $ $ MRP units of labor The curves are different; the MRC curve is higher than the labor supply curve. (b) The firm will employ three workers in this situation. Here the MRP = $4 is greater than the MRC = $8. For the fourth worker the MRP = $ and the MRC = $4. (c) The monopsonist reduces the wage by $ (from $ to $) and reduces employment by two workers (from to ). Feedback: Consider the following example: Assume a firm is a monopsonist that can hire its first worker for $ but must increase the wage rate by $ to attract each successive worker (so that the second worker must be paid $9, the third $, and so on). Parts a and b: Table for part a and table for part b (from question in Chapter and problem above). Units of labor Wage Rate labor cost (wage bill) resource (labor) cost 4 $NA 9 8 $ 8 9 $ 8 4-9

10 Units of labor product product Product price revenue revenue product $ $ 4 8 $4 8 4 Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)). MRC monopsony MRP = $4 MRC = $8 competitive wage = $ Supply monopsony MRC=Supply competitive monopsony wage = $ $ MRP units of labor The MRC schedule lies above the labor supply schedule because employing the next worker requires a higher wage in this market and you must pay all workers this higher wage. -

11 The firm will employ three workers in this situation. To see this look at the MRP and MRC columns in the table above. The first worker will generate a MRP = $4 and will have a MRC = $, thus the firm will employ this worker (the marginal revenue product for this worker is greater than his or her marginal cost). For the second worker we have MRP = $8 and MRC = $, so we employ this worker. For the third worker we have MRP = $4 is greater than the MRC = $8, so we employ this worker as well. For the fourth worker we have MRP = $ and the MRC = $4. In this case the marginal cost of this worker is greater than the worker's marginal revenue product, so we do not employ this worker. Part c: The monopsonist decreases employment by units and the equilibrium wage rate is $ less than the competitive wage. 4. Suppose that low skilled workers employed in clearing woodland can each clear one acre per month if they are each equipped with a shovel, a machete, and a chainsaw. Clearing one acre brings in $ in revenue. Each worker s equipment costs the worker s employer $ per month to rent and each worker toils 4 hours per week for four weeks each month. LO4 a. What is the marginal revenue product of hiring one low skilled worker to clear woodland for one month? b. How much revenue per hour does each worker bring in? c. If the minimum wage were $., would the revenue per hour in part b exceed the minimum wage? If so, by how much per hour? d. Now consider the employer s total costs. These include the equipment costs as well as a normal profit of $ per acre. If the firm pays workers the minimum wage of $. per hour, what will the firm s economic profit or loss be per acre? e. At what value would the minimum wage have to be set so that the firm would make zero economic profit from employing an additional low skilled worker to clear woodland? Answers: (a) $. (b) $. (= $/ hours). (c) Yes, exceeds by $. per hour. (d) The firm s loss per acre will be -9. dollars (= $ in revenue - $ in rental cost for equipment - $ in normal profit - $99 in wages for hours at $. per hour). (e) If X is the firm s labor cost per worker for one month to clear one acre, then we need $ - $ - $ X =. Solving this equation for X yields X = $8. Dividing X by hours yields a minimum wage of $ per hour as what would be needed for the firm to earn zero profit. Feedback: Consider the following example. Clearing one acre brings in $ in revenue. Each worker s equipment costs the worker s employer $ per month to rent and each worker toils 4 hours per week for four weeks each month. Part a: The marginal revenue is $. This is the revenue each worker can generate for the firm by clearing one acre. Part b: Since the worker generates $ per month and works a total of hours (4 hours per week for 4 weeks), revenue per hour equals $. (= $/). Part c: If the minimum wage were $., revenue per hour in part b exceeds the minimum wage by cents per hour (=$.-$.). -

12 Part d: Now consider the employer s total costs. These include the equipment costs as well as a normal profit of $ per acre. The total explicit cost for the firm per acre equals $. Thus, the economic profit per worker at the minimum wage equals $ (revenue) - $ (explicit cost) - $ (normal profit) - x$. (hour of labor multiplied by the minimum wage = $99) = -$9. The firm suffers a loss per acre. Part e: To determine the minimum wage necessary for the firm to break-even (earn zero economic profit, we first calculate the revenue left over for labor after accounting for normal profit and explicit cost. The revenue left over after these components have been removed is $8 (=$ - $ -$). This leaves $8 left to pay each unit of labor for the month (clears one acre). Since each worker works hours a month, the highest the break-even wage can be is $ (=$8/). This is the highest the minimum wage can be set in the industry without exit.. Suppose that a car dealership wishes to see if efficiency wages will help improve its salespeople s productivity. Currently, each salesperson sells an average of one car per day while being paid $ per hour for an eight hour day. LO a. What is the current labor cost per car sold? b. Suppose that when the dealer raises the price of labor to $ per hour the average number of cars sold by a salesperson increases to two per day. What is now the labor cost per car sold? By how much is it higher or lower than it was before? Has the efficiency of labor expenditures by the firm (cars sold per dollar of wages paid to salespeople) increased or decreased? c. Suppose that if the wage is raised a second time to $4 per hour the number of cars sold rises to an average of. per day. What is now the labor cost per car sold? d. If the firm s goal is to maximize the efficiency of its labor expenditures, which of the three hourly salary rates should it use: $ per hour, $ per hour, or $4 per hour? e. By contrast, which salary maximizes the productivity of the car dealer s workers (cars sold per worker per day)? Answers: (a) $ (b) $ per vehicle; $4 less per vehicle; increased. (c) $8 per vehicle. (d) $ per hour (e) $4 per hour. Feedback: The current labor cost per car is $ (= $ per hour times eight hours per day divided by car sold per day on average). (b) The labor cost per hour falls to $ per vehicle. It is now $4 less per vehicle. Efficiency has increased. (c) The labor cost per car is now $8 per vehicle. (d) The dealer should pay $ per hour if it wants to maximize the efficiency of labor expenditures. (e) If the dealer wants to maximize output per worker per day, it should pay $4 per hour. -