Managing Education and Training in/for Firms Part 1: How Labor Markets Work

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1 Managing Education and Training in/for Firms Part 1: How Labor Markets Work Prof. Dr. Samuel Mühlemann LMU Munich

2 Motivation To have strategic value, education and training must add value to the business and align to organizational goals Business strategy > Integrates the company's goals, policies, and actions > Influences how the company uses: Physical capital, financial capital, and human capital Goals What the company hopes to achieve in the mediumand long-term future Strategic education and training => focus on the organizational level > but we will also address the returns on investment for individuals and the government Managing Education and Training in/for firms 2

3 Broader: Strategic human resource development (HRD) is.. > the strategic management of training, development and of management/professional education interventions so as to achieve the objectives of the organisation while at the same time ensuring the full utilization of the knowledge in detail and skills of individual employees. It is concerned with the management of employee learning for the long-term keeping in mind explicit corporate and business strategies (Garavan 1991) > Emphasis on the interdependence between individual and organisational development > Need to move beyond the notion of training for training s sake > HRD interventions should not only be evaluated, but need to show justifiable cost-effectiveness and return on investment Managing Education and Training in/for firms 3

4 Strategy determines: > Amount of training required for current or future job skills > Extent to which training should be customized for particular needs > Extent to which training is restricted to specific groups of employees or open to all > Extent to which training is planned and systematically administered (formal vs. informal learning) > Importance placed on training compared to other HR practices HRD: Education and training seen as an investment BUT: Special type of education and training in Switzerland > Apprenticeship training => high turnover after graduation, thus education and training is not necessarily a long-term investment Human Resource Development 4

5 Strategic HRD and Human Capital Theory Becker (1962): Investments in general human capital must be borne by employees if labor markets are competitive > Wage = value of marginal product Firms would have no incentive to invest in general human capital, i.e., human capital that can be used in other firms > Workers make the investment, but also reap the benefits Firms and workers share the costs and benefits of firm-specific training > To avoid the hold-up problem Empirical evidence shows that firms invest in general human capital as well > Role of frictions in the labor market Human Resource Development 5

6 Human capital theory Firms will make an investment in training and development, as long as they can expect a sufficiently high post-training benefits, such as > Increased productivity (but Δ wage < Δ productivity) > Reduced hiring costs > Reduced firing costs > Lower fluctuation Expectations about post-training fluctuation rate are important Threat of poaching may cause firms to underinvest in training Managing Education and Training in/for firms 6

7 To manage education and training in/for firms, we need to > understand how labor markets work Competitive markets Frictional markets > understand the predictions of human capital theory both in competitive and frictional labor markets, regarding hiring and training decision of firms individual investment decisions for education and training the role of the government (particularly in frictional markets) > Empirical research is important to test the predictions of theory and to evaluate the effects and the returns to education and training programs Issues in identifying causal effects of education and training, because of self-selection into education and training (often based on characteristics that are not observed in the data, such as innate ability or motivation) Prof. S. Mühlemann Managing Education and Training in/for firms 7

8 Outline of the course 1. How labor markets work 1. General overview 2. Labor supply 3. Labor demand 4. Wage determination 5. Introduction to frictional labor markets 2. Human capital theory 1. Returns to training for individuals 2. Returns to training for firms Prof. S. Mühlemann Managing Education and Training in/for firms 8

9 3. Recruitment and training in frictional labor markets 1. Signaling and Screening 2. Financing of training in frictional labor markets 3. The role of recruitment costs for skilled workers and trainees 4. Financing training as a device to attract and retain skilled workers 4. Workplace learning 1. Evaluating workplace learning 2. Formal vs. informal training 3. Apprenticeship training The apprenticeship market Costs and benefits of apprenticeship training How does the threat of poaching affect the provision of apprenticeships? Financial incentives for apprentices and firms / Training vouchers Prof. S. Mühlemann Managing Education and Training in/for firms 9

10 5. International aspects of workplace training 1. An overview of international education and training systems and current initiatives about the role of the firm in vocational training 2. Empirical evidence on training and recruitment strategies in multinational firms located in Switzerland 3. The Spanish VET system: would the adoption of the Swiss VET model be a cost-effective strategy? Results of a simulation study. Prof. S. Mühlemann Managing Education and Training in/for firms 10

11 Basic Literature Borjas, G.E (2015). Labor Economics, 7/E. McGraw-Hill. Ehrenberg, R.G. & Smith, R.S. (2015). Modern Labor Economics Theory and Public Policy. 12th Edition/Pearson. Manning, A. (2011). Imperfect competition in the labor market. In: O. Ashenfelter & D. Card (eds.), Handbook of Labor Economics, Vol. 4, Chapter 11, Muehlemann, S. (2016). The Costs and Benefits of Workplace Training. OECD Education Working Papers No Paris: OECD Publishing. Wolter, S.C. & P. Ryan (2011). Apprenticeship. Handbook of Economics of Education, Vol. 3, ed. by R. Hanushek, S. Machin, L. Wössmann. Amsterdam: Elsevier North-Holland, (Future) password for lecture slides: Prof. S. Mühlemann Managing Education and Training in/for firms 11

12 Time schedule Monday March 26th: 9h15-12h00 Lectures (Part 1) 13h15-14h00 Self-study: preparation time for exercises (last slides of part 1) 14h15-18h00 Lectures (Part 1 & 2) Tuesday March 27th: 9h15-12h00 Lectures (Part 3) 13h15-15h00 Lectures (Part 4a) Monday April 23th: 9h15-12h00 Lectures (Part 4a,b) 13h15-14h00 Self-study: preparation time for exercises 14h15-18h00 Lectures (Part 4b) Tuesday April 24 th : 9h15-12h00 Lectures (Part 4b & Part 5) 13h15-15h00 Lectures (Part 5, Q&A) Prof. S. Mühlemann Managing Education and Training in/for firms 12

13 Outline Part 1: 1. How labor markets work 2. Labor demand 3. Labor supply 4. Introduction to frictional labor markets and search theory 1. Frictions on the employee side of the market 2. Frictions on the employer side of the market Prof. S. Mühlemann Managing Education and Training in/for firms 13

14 1. HOW LABOR MARKETS WORK Prof. S. Mühlemann Managing Education and Training in/for firms 14

15 The Labor Market: Definitions, Facts, and Trends The market that allocates workers to jobs and coordinates employment decision is the labor market, which could be: > national labor market > regional > local > external > internal labor market Prof. S. Mühlemann Managing Education and Training in/for firms 15

16 Prof. S. Mühlemann Managing Education and Training in/for firms 16

17 Qualification levels of the Swiss workforce Source: Swiss Federal Statistical Office Prof. S. Mühlemann Managing Education and Training in/for firms 17

18 Percentage of today s young people expected to complete university education (tertiary-type A) in their lifetime Swiss unemployment rates by education level Economic and Labour Market Outcomes 32% 12% 3 Unemployment rate of year-olds - Men and Women Below upper secondary 7.6% 6% 12 Upper secondary and post-secondary non-tertiary 3.3% 2.9% 7. Tertiary 2.6% 1.8% 4. Unemployment rate of year-olds - Women Below upper secondary 7.8% 6.7% 12 Upper secondary and post-secondary non-tertiary 3.2% 3.1% 8. Tertiary 3.4% 2.3% 5. Average Source: earnings OECD premium Education for at a Glance year-olds 2013 Country 2011 Note Switzerland or latest year with tertiary education** available Prof. S. Mühlemann Managing Education and Training in/for firms 18

19 The markets in which firms must operate Prof. S. Mühlemann Managing Education and Training in/for firms 19

20 2. LABOUR SUPPLY Prof. S. Mühlemann Managing Education and Training in/for firms 20

21 The supply of labor Labor is the most abundant and important factor of production, therefore, a country s economic performance depends on the willingness of its people to work. A person s discretionary time (16 hours a day) can be spent: (a) working for pay to derive income (Y) for consumption, and (b) on leisure (L). Some Basic Concepts Recall that the demand for good/service depends on: 1. The opportunity cost of the good = market price 2. One s level of wealth 3. One s set of preferences Prof. S. Mühlemann Managing Education and Training in/for firms 21

22 Opportunity Cost of Leisure The demand for leisure depends on: The opportunity cost of leisure, which is equal to one s wage rate or the extra earnings a worker can take home from an extra hour of work. Wealth and Income Wealth and income include: (a) family s holdings of bank accounts (b) financial investments (c) physical property or properties The effects of increases in income and wages on leisure-work preferences of a person can be categorized as: 1. Income effect 2. Substitution effect Prof. S. Mühlemann Managing Education and Training in/for firms 22

23 Income and Substitution effects Defining the Income Effect If income increases, holding wages constant, desired hours of work will go down demand for leisure hours will increase while the hours of work supplied by a worker to the labor market decreases. That is: Income Effect = ΔH ΔY ȁ W < 0 Defining the Substitution Effect If income is held constant, an increase in the wage rate will raise the price and reduce the demand for leisure, thereby increasing work incentives an increase in the opportunity cost of leisure reduces the demand for leisure. That is: Substitution Effect = ΔH ȁ Y > 0 ΔW Prof. S. Mühlemann 23

24 Observing Income and Substitution Effects Separately It is possible to observe situations or programs that create only one effect or the other receiving an inheritance is an example of the income effect, which induces the person to consume more leisure, thus reducing the willingness to work. Both Effects Occur When Wages Rise The labor supply response to a simple wage increase will involve both an income effect and a substitution effect; and both effects working in opposite directions creates ambiguity in predicting the overall labor supply response in many cases see Figure 6.1. If the income effect is stronger, the person will respond to a wage increase by decreasing his or her labor supply the labor supply curve will be negatively sloped that is, as W H. If the substitution effect dominates, the person s labor supply curve will be positively sloped that is, as W H. Prof. S. Mühlemann Managing Education and in/for Training Firms in/for firms 24

25 An Individual Labor Supply Curve Can Bend Backward Source: Ehrenberg & Smith (2015), Fig. 6.1 Prof. S. Mühlemann Managing Education and Training in/for firms 25

26 Empirical studies find that the supply of labor will be upwardsloping in general, which is what we assume for now. Source: Ehrenberg & Smith (2015), Fig. 2.9 Prof. S. Mühlemann 26

27 If other factors change, e.g. if the wage rate of insurance agents increases, but the wage rate (W) of paralegals is unchanged, then the L S curve of paralegals will shift to the left. Wages for Paralegals Supply of Paralegals when Salaries of Insurance Agents are: High Low Number of Paralegals Prof. S. Mühlemann Managing Education and Training in/for firms 27

28 Perfect competition: Supply of labor to Firms We assume that the labor market for paralegals is perfectly competitive, and that no firm will offer a wage that is above or below what the market wage indicates firms are wage takers: > Labor supply curves of paralegals to a firm are horizontal see Figure > At the on-going wage of W 0, employers can hire all the paralegals they need and each employer faces S 0 supply curve. > If the paralegal wage falls from W 0 to W 1, employers can still hire as much as they want at the lower wage, and each firm s or employer s labor supply curve becomes S 1 with the same slope as the supply curve S 0. Prof. S. Mühlemann Managing Education and Training in/for firms 28

29 Supply of Paralegals to an Individual Firm at Alternative Market Wages Source: Ehrenberg & Smith (2015), Fig Prof. S. Mühlemann Managing Education and Training in/for firms 29

30 The Reservation Wage A worker takes into consideration some key factors in determining whether or not to work in the labor market: > Reservation wage and the earning possibilities. > Commute time per day (fixed costs of working) A reservation wage (W R ) is the wage below which a person will not work in the labor market that is, W R represents the value placed on an hour of lost leisure time. Often, people are thought to behave as if they have both a reservation wage and a certain number of work hours that must be offered before the consideration to take a job. Prof. S. Mühlemann Managing Education in/for Firms 30

31 Empirical Findings on the Income and Substitution Effects Labor supply theory suggests that the choices workers make with respect to the desired hours of work depends on: > Wealth > Wage rate > Leisure-income preferences A comprehensive review of numerous studies of the labor supply of men finds that the sizes of the estimated effects vary with both data and the statistical methodology used. > Overall, the observed substitution effects are positive while the observed income effects are negative. Studies of the labor supply behavior of women generally have found a greater responsiveness to wage changes than is found among men. Prof. S. Mühlemann Managing Education in/for Firms 31

32 3. LABOR DEMAND Prof. S. Mühlemann Managing Education and Training in/for firms 32

33 Outline 1. Profit Maximization > Marginal Income from an Additional Unit of Input > Marginal Expense of an Added Input 2. The Short-Run Demand for Labor When Both Product and Labor Markets Are Competitive > A Critical Assumption: Declining MPL > From Profit Maximization to Labor Demand 3. The Demand for Labor in Competitive Markets When Other Inputs Can Be Varied > Labor Demand in the Long Run > More than Two Inputs Prof. S. Mühlemann Managing Education and Training in/for firms 33

34 4. Labor demand elasticities > Own wage elasticity > Cross-elasticity Prof. S. Mühlemann Managing Education and Training in/for firms 34

35 1. Profit Maximization For products price-taking and inputs price-taking firm, profitmaximizing decisions by a firm mainly involve the question of whether, and how, to increase or decrease output. The search for profit improving possibilities means that small ( marginal ) changes must be made almost daily: > Major decisions to open a new plant or introduce a new product line are relatively rare, once made. > Must approach profit maximization incrementally through the trial-and-error process of small changes. > Incrementally decide on its optimal level of output by: Q when MR > MC Q when MR < MC, and that Q is profit maximizing or loss minimizing when MR = MC. Prof. S. Mühlemann Managing Education in/for Firms 35

36 > A firm can expand or contract output only by altering its use of inputs (capital and labor). Use more of an input if its MRP additional income > MEI (additional expense). Reduce the employment of an input if its MRP < MEI. No further changes in an input are desirable if its MRP = MEI. Prof. S. Mühlemann Managing Education in/for Firms 36

37 Marginal Income from an Additional Unit of Input We assume that labor (L) and capital (K) are needed to produce a given level of output (Q). That is: Q = f (L, K) Marginal Product Marginal product of labor: MP L = ΔQ/ΔLȁ K constant Marginal product of capital: MP K = ΔQ/ΔKȁ L constant Marginal Revenue Recall that: > In perfectly or purely competitive product market: MR = AR = P > In imperfectly or impurely competitive product market: MR < AR = P Prof. S. Mühlemann Managing Education in/for Firms 37

38 Marginal Income from an Additional Unit of Input Marginal Revenue Product Marginal revenue product of L: MRP L = MP L MR VMP L = MRP L = MP L P Marginal revenue product of K: MRP K = MP K MR VMP K = MRP K = MP K P Prof. S. Mühlemann Managing Education and Training in/for firms 38

39 Marginal Expense of an Added Input ΔL and/or ΔK will add to or subtract from the firm s total costs Marginal expense of labor (ME L ) is the change in total labor cost for each additional unit of labor hired > If the labor market is competitive, each worker hired is paid the same wage (W) as all other workers, hence: ME L = W horizontal supply curve > If the capital market is competitive, each additional unit of capital will have the same rental cost (C), hence: ME K = C Prof. Dr. Samuel Mühlemann Managing Education in/for Firms 39

40 2. The Short-Run Demand for Labor When Both Product and Labor Markets Are Competitive In the short-run, the firm cannot vary its stock of capital, therefore, the production function takes the form: Q = f (L, K) This means the firm needs only to decide whether to alter its output level; how to increase or decrease output is not an issue, because only the employment of labor (L) can be adjusted. Prof. Dr. Samuel Mühlemann Managing Education and Training in/for firms 40

41 The Short-Run Demand for Labor When Both Product and Labor Markets Are Competitive When both product and labor markets are competitive, it is assumed that: > All producers or sellers are price takers in the product market. > All employers of labor are wage takers in the labor market. Analysis of a firm s production and employment is in the short run where the firm cannot vary its capital stock. Prof. S. Mühlemann Managing Education and Training in/for firms 41

42 A Critical Assumption: Declining MP L Since K is constant in the short-run, adding extra unit of L increases output in each case MP L is positive to some point. Eventually, adding more L will produce progressively smaller increments of output law of diminishing marginal returns. This means that as employment expands, each additional worker has a progressively smaller share of the capital stock to work with. Prof. S. Mühlemann Managing Education and Training in/for firms 42

43 From Profit Maximization to Labor Demand Profits are maximized only when employment is such that any further one-unit change in labor would have a marginal revenue product equal to marginal expense: MRP L = ME L (3.4) MP L P = W (3.5) MP L = W/P (3.6) Prof. S. Mühlemann Managing Education in/for Firms 43

44 Labor Demand in Terms of Real Wages Labor demand can be analyzed in terms of either real or money wages. The negative slope of the labor demand curve indicates that each additional unit of labor employed produces a progressively smaller increment in output. At any real wage determined by the market, the firm should employ labor up to the point at which MP L equals the real wage (W/P) the firm s demand for labor in the short-run is equivalent to the downward-sloping segment of its MP L schedule: > At E 0 employment level: MP L = W/P profit maximizing level of employment. > At E 1 employment level: MP L > W/P employment level E 1 is less than E 0 ; firm could increase profit by adding L. > At E 2 employment level: MP L < W/P employment level E 2 is greater than E 0 ; firm could increase profit by decreasing L. Prof. Dr. Samuel Mühlemann Managing Education in/for Firms 44

45 Demand for Labor in the Short Run (Real Wage) Source: Ehrenberg & Smith (2015), Fig. 3.1 Prof. S. Dr. Mühlemann Samuel Mühlemann Managing Education and Training in/for firms 45

46 Labor Demand in Terms of Money Wages In some circumstances, labor demand curves are more readily conceptualized as downward-sloping functions of money wages. MRP L does not decline because added workers are incompetent, it declines because capital stock is fixed, hence added workers have less capital or equipment to work with. The fundamental point is: the labor demand curve in the short-run slopes downward because it is the MRP L curve, which slopes downward because of labor s diminishing marginal product. Since MRP L = W for a profit maximizer who takes wages as given, the MRP L curve and labor demand curve (MP L ) must be the same. The marginal product of an individual is not a function solely of his or her personal characteristics: > It depends on the number of similar employees hired by the firm and the firm s capital stock. Prof. S. Mühlemann Managing Education in/for Firms 46

47 Source: Ehrenberg & Smith (2015), Table 3.2 Prof. S. Mühlemann Managing Education in/for Firms 47

48 Demand for Labor in the Short Run Source: Ehrenberg & Smith (2015), Fig. 3.2 Prof. S. Mühlemann Managing Education and Training in/for firms 48

49 Market Demand Curves A market demand curve (or schedule) is the summation of the labor demanded by all firms in a particular labor market at each level of the real wage When real wage changes (falls or increases), the number of workers that existing firms want to employ changes (increases or falls) Objections to the Marginal Productivity Theory of Demand Employers do not go around verbalizing MRP L it is a theoretical concept, which assumes a degree of sophistication that most employers do not have With fixed capital stock, it seems that adding labor would not add to output at all but workers take their turns in using the fixed capital stock such that labor will generally have a marginal product greater than zero Prof. Dr. Samuel Mühlemann Managing Education in/for Firms 49

50 3. The Demand for Labor in Competitive Markets When Other Inputs Can be Varied Labor Demand in the Long Run In long-run, the firm s ability to adjust other inputs such as capital will affect the demand for labor To maximize profits in the long-run, the firm must adjust L and K such that each input s MRP is equal to its ME MP L P = W MP K P = C Rearranging equations yields: P = W/MP L P = C/MP K W/MP L = C/MP K Prof. Dr. Samuel Mühlemann Managing Education in/for Firms 50

51 W is the added cost or marginal cost (MC) of producing an MP L added unit of output when using labor to generate the increase in output C is the marginal cost (MC) of producing an extra unit of output MP K when using capital to generate the increase in output To maximize profits, the firm must adjust its labor and capital inputs so that the marginal cost of producing an added unit of output using labor is equal to the marginal cost of producing an added unit of output using capital Prof. S. Mühlemann Managing Education in/for Firms 51

52 More Than Two Inputs Capital and labor are not the only inputs used in the production process. Labor can be subdivided into many categories by age, educational level, and occupation. Other inputs in the production process include materials and energy. For all other inputs, the equality of MC in using these inputs to produce an added unit of output as given by equation (3.8c) applies. Prof. S. Mühlemann Managing Education in/for Firms 52

53 If Inputs Are Substitute in Production If two inputs are substitutes in production, and if an increase in the price of one input shifts the demand for another input to the left as in panel (a) of Figure 3.3, then the scale effect dominates the substitution effect inputs are gross complements. If the increase in the price of one input shifts the demand for the other input to the right as indicated in panel (b) of Figure 3.3, then the substitution effect dominates inputs are gross substitutes. If Inputs Are Complements in Production When two inputs must be used together in some proportion, they are considered to be perfect complements or complements in production that is, no substitution effect, only a scale effect. Prof. S. Mühlemann Managing Education and Training in/for firms 53

54 Effect of Increase in the Price of One Input (k) on Demand for Another Input (j), Where Inputs Are Substitutes in Production Prof. S. Mühlemann Source: Ehrenberg & Smith (2015), Fig. 3.3 Managing Education and Training in/for firms 54

55 Application: Skill-biased technological change (SBTC) Seminal paper by Bresnahan, Brynjolfsson & Hitt (QJE, 2002) > SBTC represented by new forms of work organization (WO) team use team-building activities teamwork as a promotion criterion the use of employee involvement groups or quality circles workers decide on the pace of work and methods > and information technology (ITC) They find that technological change is complementary to skills, because work organization and ITC was positively associated with human capital investment, as measured by importance of screening for education in hiring the fraction of workers receiving training the importance of cross training 55

56 4. Labor demand elasticities The own-wage elasticity of demand for a category of labor is defined as the percentage change in its employment (E) induced by a 1 percent increase in its wage rate (W): η ii = % ΔE i % ΔW i (4.1) 1. η ii is relatively elastic labor demand if the % ΔE i > % ΔW i 2. η ii is relatively inelastic labor demand if the % ΔE i < % ΔW i 3. η ii is unitary elastic labor demand if the % ΔE i = % ΔW i 4. η ii is perfectly elastic labor demand if the % ΔE i is infinite 5. η ii is perfectly inelastic labor demand if the % ΔE i is zero for positive or negative changes in the wage rate (% Δw i ) Prof. S. Mühlemann Managing Education and Training in/for firms 56

57 Relative Demand Elasticities Source: Ehrenberg & Smith (2015), Fig. 4.1 Prof. S. Mühlemann Managing Education and Training in/for firms 57

58 Different Elasticities along a Demand Curve Prof. S. Mühlemann Source: Ehrenberg & Smith (2015), Fig. 4.2 Managing Education and Training in/for firms 58

59 The Hicks-Marshall Laws of Derived Demand These laws assert that, other things equal, the own-wage elasticity of demand for a category of labor is generally higher under the following conditions: 1. When price elasticity of demand for the product being produced is higher. 2. When other factors of production can be more easily substituted for the category of labor. 3. When the supply of other factors of production is more highly elastic. 4. When the cost of employing the category of labor is a larger share of the total costs of production. Prof. S. Mühlemann Managing Education and Training in/for firms 59

60 Demand for the Final Product The greater the price elasticity of demand for the final product, the larger the percentage decline in output (- and the greater percentage loss in employment) associated with a given price increase the greater the elasticity of demand for the product, the greater the elasticity of demand for labor. The implication is that wage elasticities will be higher in the long run than in the short run. Substitutability of Other Factors When substitution possibilities exist, a reduction in employment will accompany whatever reductions are caused by the scale effect the easier it is to substitute other factors of production, the greater the wage elasticity of labor demand. Prof. S. Mühlemann Managing Education and Training in/for firms 60

61 The Supply of Other Factors If an increase in the wages of unskilled workers caused employers to attempt to substitute skilled employees for unskilled employees, the wages of the skilled workers (fixed number) would be bid up by employers. If the price of other inputs did not increase when employers attempted to increase their use, the substitution effect the wage elasticity of labor demand would be larger. The Share of Labor in Total Costs The share of labor cost (TC L = wl) in total costs of production [TC(Q) = rk + wl or ck + wl] is expressed as: wl, thus, the greater the category s share in total rk + wl costs, the greater the wage elasticity of demand. Prof. S. Mühlemann Managing Education and Training in/for firms 61

62 4. WAGE DETERMINATION Prof. S. Mühlemann Managing Education and Training in/for firms 62

63 The Determination of the Wage The wage rate that prevails in the labor market depends on L D and L S, regardless of whether labor unions and/or nonmarket factors are involved see Figure The Market-Clearing Wage The wage rate (W e ) at which L D equals L S is the market-clearing wage that is, no labor surplus and/or no labor shortage. For any wage (W 1 ) lower than W e : L D > L S EDL, and with adjustments from employers/demanders, wage rises to W e. For any wage (W 2 ) higher than W e : L D < L S ESL, and with adjustments from workers/suppliers, wage falls to W e. W e becomes the going wage that individual employers and employees face see Figures 2.12 and Prof. S. Mühlemann Managing Education and Training in/for firms 63

64 Market demand and supply Source: Ehrenberg & Smith (2015), Fig Prof. S. Mühlemann Managing Education and Training in/for firms 64

65 Market demand and supply at the Market and Firm Levels Source: Ehrenberg & Smith (2015), Fig Prof. S. Mühlemann Managing Education and Training in/for firms 65

66 Disequilibrium and Nonmarket Influences The labor market is subject to forces that impede the adjustment of both wages and employment to changes in supply or demand: > Changing jobs often requires an employee to invest in new skills or bear the costs of moving. > Hiring workers can involve an initial investment in search and training, while firing them or cutting their wages can be perceived as unfair, which may affect moral and productivity. Other barriers to adjustment are rooted in nonmarket forces: > Government programs or laws such as minimum wage laws usually serve to keep wages above market levels, which could result in widespread unemployment. > Customs or institutions (labor unions) also constrain the choices of individuals and firms. Prof. S. Mühlemann Managing Education and Training in/for firms 66

67 Economic Rents for workers With respect to the labor market, economic rents can be defined as the difference between the wage workers are actually paid on a job and the workers reservation wages. > Economic rents for workers sum the area between the marketclearing wage and the labor supply curve see Figure The labor supply curve of any occupation or industry is a schedule of reservation wages that indicates the labor forthcoming at each wage level each worker potentially has a different reservation wage, hence rents will differ for each. The reservation wage of a worker is the wage below which the worker would refuse (or quit) the job in question. > It is the opportunity cost to the individual worker for giving up hours of leisure for market work. Prof. S. Mühlemann Managing Education and Training in/for firms 67

68 Labor Supply to the Military: Different Preferences Imply Different Rents Source: Ehrenberg & Smith (2015), Fig Prof. S. Mühlemann Managing Education and Training in/for firms 68

69 5. FRICTIONS IN THE LABOR MARKET Prof. S. Mühlemann Managing Education and Training in/for firms 69

70 Outline 1. Frictions on the employee side of the market > The law of one price > Mobility and job search costs 2. Frictions on the employer side of the market > Hiring costs => Part III Hiring in frictional labor markets > Training costs => Part II Human capital and Part III Prof. S. Mühlemann Managing Education and Training in/for firms 70

71 1. Frictions on the Employee Side of the Market The Law of One Price Monopsonistic Labor Markets: A Definition Profit Maximization under Monopsonistic Conditions How Do Monopsonistic Firms Respond to Shifts in the Supply Curve? Monopsonistic Conditions and the Employment Response to Minimum Wage Legislation Job Search Costs and Other Labor Market Conditions Monopsonistic Conditions and the Relevance of the Competitive Model Prof. S. Mühlemann Managing Education and Training in/for firms 71

72 The Law of One Price (LOP) Workers who are of equal skills within occupations will receive the same wage there will be no wage differentials. Assumptions underlying the LOP: > Every employee has information about available jobs information is costless. > Mobility or job search across employers is costless. > Labor supply curve is horizontal. Prof. S. Mühlemann Managing Education and Training in/for firms 72

73 Frictions on the Employee Side of the Market Mobility or job search across employers is NOT costless. > Job search takes time and effort. > Costs of job search include: a) application printing résumés and postage b) interview buying expensive clothes for interview and roundtrip fares c) travel hiring movers if employed d) psychological costs missing friends and family members. Costs of job search/mobility make the supply curve to be upward sloping and not horizontal as assumed earlier. Prof. S. Mühlemann Managing Education and Training in/for firms 73

74 The Supply of Labor to Firm A: Worker-Mobility Costs Increase the Slope of the Labor Supply Curve Facing Individual Employers Higher mobility costs will elicit low labor/employment responses if wage changes. Lower mobility costs will elicit high labor/employment responses if wage changes. Source: Ehrenberg & Smith (2015), Fig. 5.1 Prof. S. Mühlemann Managing Education and Training in/for firms 74

75 Monopsonistic Labor Markets: A Definition A labor market monopsonist is the only buyer/employer of labor in its labor market. BUT: A labor market can be monopsonistic if there are few - i.e., more than one - but not a high number of buyers/employers of labor (=> job opportunities) The employer faces an upward labor supply curve but its ME L (or MC L ) is higher than the wage rate. Profit maximization under monopsonistic conditions: > profit-maximizing firms will hire as long as MRP L > ME L > hiring stops when MRP L = ME L > when firms face upward sloping supply curves, the ME L exceeds the wage. Prof. S. Mühlemann Managing Education and Training in/for firms 75

76 Why the Marginal Expense of Labor Exceeds the Wage Rate The marginal expense of labor (ME L ) exceeds the wage rate because: > potential employees find it costly to change jobs, so the firm must be willing to pay higher wages to attract workers from other employers (or to participate in the labor market so that the wage > individual reservation wage) > the ME L includes the wages paid to the extra worker plus the additional cost of raising the wage for all other workers. Prof. S. Mühlemann Managing Education and Training in/for firms 76

77 Source: Ehrenberg & Smith (2015), Table 5.1 Prof. S. Mühlemann Managing Education and Training in/for firms 77

78 Source: Ehrenberg & Smith (2015), Fig. 5.2 Prof. S. Mühlemann Managing Education and Training in/for firms 78

79 The Firm s Choice of Wage and Employment Levels The monopsonist hires workers up to the point where: MRP L = ME L The labor market effects caused by ME L > W : > A labor market monopsonist hires less workers in comparison to the competitive employer(s). > A labor market monopsonist pays a wage that is less than the competitive wage exploits workers. Prof. S. Mühlemann Managing Education and Training in/for firms 79

80 Profit-Maximizing Employment and Wage Levels in a Firm Facing a Monopsonistic Labor Market Source: Ehrenberg & Smith (2015), Fig. 5.3 Prof. S. Mühlemann Managing Education and Training in/for firms 80

81 Monopsonistic Conditions and Firms Wage Policies The employers in monopsonistic labor markets must decide on the wage to pay unlike in the perfectly competitive labor markets where firms are wage takers. Firms must make labor market decisions that allow them to remain competitive in their product markets. Product and labor market constraints may cause firms in monopsonistic labor markets to offer different wages to equivalent workers. Due to the unlikelihood that S L and MRP L curves would be exactly the same for different firms in the same labor market, it should be no surprise if exactly comparable workers have different marginal productivities and receive different wages at different firms. Prof. S. Mühlemann Managing Education and Training in/for firms 81

82 How Do Monopsonistic Firms Respond to Shifts in the Supply Curve? The labor market monopsonistic firm does not really have a labor demand curve it has MRP L curve. The monopsonistic firm is not a wage taker and its MRP L curve shows various levels of employment of which there is only one profit-maximizing level of employment and only one associated wage rate. Prof. S. Mühlemann Managing Education and Training in/for firms 82

83 Effects of a Mandated Minimum Wage A mandated wage (W m ) prevents a firm from paying a wage less than W m this creates a perfectly elastic labor supply curve facing the firm, thus altering its ME L curve. A profit-maximizing firm will hire labor where the MRP L insects the perfectly elastic labor supply curve (ME L curve) created by W m see employment at E m in Figure 5.5. For a monopsonistic firm, W m can simultaneously increase the average cost of labor and reduce ME L the decrease in marginal expense will induce the firm to expand output and employment in the short run. Prof. S. Mühlemann Managing Education and Training in/for firms 83

84 Minimum-Wage Effects under Monopsonistic Conditions: Both Wages and Employment Can Increase in the Short Run BDS = Labor supply curve based on a mandated W m BDEM = Marginal expense of labor curve (ME L ) based on W m MRP L = ME L (which is given as BDEM based on W m ) E m Source: Ehrenberg & Smith (2015), Fig. 5.5 Prof. S. Mühlemann Managing Education and Training in/for firms 84

85 Monopsonistic Conditions and the Employment Response to Minimum Wage Legislation Legislated increases in W min raise wages. Modest increase in W min can reduce ME L. Fall in ME L may cause some firms/employers to experience increases in employment. Higher total labor costs due to W min may force some firms/employers to close. Prof. S. Mühlemann Managing Education and Training in/for firms 85

86 Empirical evidence: Effect of a minimum-wage increase in New Jersey (Card & Krueger 1994) NJ raised minimum wages on April 1st 1992 from $4.25 to $5.05 (a substantial increase, almost 20%) Main businesses affected: fast food industry Authors collected data in the border region between NJ and Pennsylvania, where the minimum wage stayed at $4.25, before the introduction (February) and afterwards (November). Why not just observe employment levels before and after (first-differences) the change in minimum wages in NJ? > There might be a general trend in the labor market that causes fluctuations in employment (seasonal factors, business cycles, etc.) Prof. S. Mühlemann Managing Education and Training in/for firms 86

87 Common trend assumption in DID models Critical assumption of DID: Common trend What does this mean? > In the absence of the minimum wage increase in New Jersey, the difference in employment between February and November 1992 would have been the same in both states > This assumption may hold if businesses close to the state border face similar macroeconomic conditions Assumption: Additive structure for potential outcomes in the non-treatment state: E y 0ist s, t = γ s + λ t where s denotes state, and t denotes time. In this setup, employment is determined only by state and time Prof. S. Mühlemann Managing Education and Training in/for firms 87

88 Difference-in-differences estimation The additive state effect is similar to unobserved individual effect in the fixed-effects model Let D st denote high-minimum-wage state in a given period Assuming that the difference in employment, E[y 1ist y 0ist ȁs, t] between high and low-minimum-wage states is constant and denoted δ, then where E[ε ist ] = 0. y ist = γ s + λ t + δd st + ε ist, Prof. S. Mühlemann Managing Education and Training in/for firms 88

89 Difference-in-differences estimation Thus, for Pennsylvania (PA), the difference in employment between February and November 1992 is simply E y ist s = PA, t = Nov E y ist s = PA, t = Feb = λ Nov λ Feb and for New Jersey (NY) E y ist s = NJ, t = Nov E y ist s = NJ, t = Feb = λ Nov λ Feb + δ Prof. S. Mühlemann Managing Education and Training in/for firms 89

90 Difference-in-differences estimation Finally, the population difference-in-differences is ሼE y ist s = NJ, t = Nov E y ist s = NJ, t = Feb ሽ ሼE y ist s = PA, t = Nov E y ist s = PA, t = Feb ሽ = δ, which is the causal effect of increasing the minimum wage on employment. Interpretation: The treatment (minimum-wage-increase) is a deviation from the common employment trend of the two states. Differences by the level of employment between PA and NJ are captured by the state fixed effect. Prof. S. Mühlemann Managing Education and Training in/for firms 90

91 Prof. S. Mühlemann Managing Education and Training in/for firms 91

92 Card & Krueger (1994) Prof. S. Mühlemann Managing Education and Training in/for firms 92

93 Employment rate Common trend assumption Employment trend in treatment state (NJ) Employment trend in control state (PA) Counterfactual employment trend in treatment state (NJ) Before After Treatment Effect Time Prof. S. Mühlemann Managing Education and Training in/for firms 93

94 Job Search Costs and Other Labor Market Outcomes Despite the job search costs, some workers high wage levels may be due to luck they are lucky to be employed by a high-paying/high-productivity employer. Job mobility/search costs for workers may explain why: > Wages increase or improve over time with workers labor market experience or activity. > Wages increase with workers length of time (tenure) with their particular employers. Prof. S. Mühlemann Managing Education and Training in/for firms 94

95 Wage Levels, Luck, and Search Employee mobility costs can create, other things equal, monopsonistic conditions that result in pay differences among workers who have equal productive capabilities. > The implication is that to some extent, a worker s wage depends on luck some workers will be lucky to obtain a job offer from a high-paying employer. Workers who see their jobs as a poor match (due to low pay) have more incentive to search for other offers than the lucky ones who have good matches with high wages. Prof. S. Mühlemann Managing Education and Training in/for firms 95

96 Wage and Labor Market Experience Workers who have spent more time in the labor market have had more chances to acquire better offers and thus improve upon their initial job matches that is, workers wages improve the longer they are active in the labor market. Workers that spent more time in the labor market may also acquire more human capital => topic of next session! Wages and Job Tenure With costly job searches, workers who are fortunate enough to find jobs with high-paying employers will have little incentive to continue searching. Those who have longer job tenure with their employers also tend to have higher wages. Prof. S. Mühlemann Managing Education and Training in/for firms 96

97 Job Search Costs and Unemployment Job search costs can help to explain the existence (and level) of unemployment the longer it takes for a worker to receive an acceptable offer, the longer the unemployed worker will remain unemployed. Monopsonistic Conditions and the Relevance of the Competitive Model: The competitive model may offer predictions that are at least partially contradicted by evidence but it does not mean that it is irrelevant, especially in the long run. The major difference between the competitive and monopsonistic models is the assumption about employee mobility costs. Prof. S. Mühlemann Managing Education and Training in/for firms 97

98 2. Frictions on the employer side of the market Categories of Quasi-Fixed Costs: The frictions on the employer side of the market cause firms to bear quasi-fixed costs that are difficult to cut in the short run. Quasi-fixed costs fall into two categories: investments in their workforce and certain employee benefits. Labor Investments => part 2 and part 3! Costs of hiring replacements such as advertising the position, screening, interviewing, wine and dine, and terminating severance pay, and Costs of formal or informal training firms incur explicit and implicit costs of training employees. Prof. S. Mühlemann Managing Education and Training in/for firms 98

99 EXERCISE Prof. S. Mühlemann Managing Education and Training in/for firms 99

100 Labor demand in competitive and monopsonistic labor markets Assume your firm operates in a competitive product market. The marginal product of labor is MP L = L, where L is the number of workers employed. For simplicity assume that the price per unit of output is $ 1 (=> value of the marginal product = marginal product). a. How many workers will you hire if you operate in a competitive labor market, and the going wage rate is $6/hour? b. How many workers will you employ if the government introduces a minimum wage of $8/hour? Prof. S. Mühlemann Managing Education and Training in/for firms 100

101 Labor demand in competitive and monopsonistic labor markets c. Marginal product of labor remains as under (a). However, now you assume that your firm operates in a monopsonistic labor market, and you face the following upward-sloping labor supply curve: w = L. This implies that the firm s marginal costs for labor are MC L = wl/ L = ([ L] L)/ L) = L Reminder: In order to maximize profits, you will always hire new employees up to the point where the marginal costs of labor equal the marginal product of labor. How many workers will you hire? What is the wage paid to the workers? Compare the results to your answer in question a). Illustrate graphically. Prof. S. Mühlemann Managing Education and Training in/for firms 101