Using Elasticity to Predict Cost Incidence. A Definition & A Question. Who pays when payroll tax added to wage rate?

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1 Using Elasticity to Predict Cost Incidence A Definition & A Question Definition of Incidence: the fact of falling upon; in this case, where costs fall A Question for you what does a statement like this mean? The health benefits provided to GM employees adds $500 to what every consumer pays when they buy a GM car. Who pays when payroll tax added to wage rate? Wage rate S L - Market W Equilibrium Wage bill D L - Market E Equilibrium Employment level

2 Remember Own-Price Elasticities Demand: Supply: Higher the elasticity, Higher the greater demand elasticity, greater response to price supply response to change price change S E S I W with tax W 0 D E D I Change in Emp. When D I Change in Emp When D E Change in Emp when S E Change in Emp when S I Who Bears Cost of New Payroll Tax? Case 1: Employer bears entire cost Possible in very short run in firm where demand is perfectly inelastic W 0 + tax W 0 Employer loss E 0 D 0 S 0 Who Bears Cost of New Payroll Tax? Case 2: Employees bear entire cost in form of lower wages Possible in short run in firm where supply is perfectly inelastic W 0 W 0 -tax Employee loss E 0 S 0 D 0

3 Who Bears Cost of New Payroll Tax? Case 3: Shared Cost (Moderate elasticity of supply & demand) Employees bear cost in form of lower wages & employment Employer bears cost in form of wage reduction less than tax W 0 +tax W 0 W * W 0 -tax Employer loss E t E * E 0 S 0 D 0 Employee loss Point: The more inelastic the demand for labor, the less employment will decrease with a payroll tax, i.e., the firm will bear more of the cost of a payroll tax, ceteris paribus The more inelastic the supply of labor, the smaller the decrease in supply, i.e., labor will bear the cost of a payroll tax, ceteris paribus COMPENSATING WAGE DIFFERENTIAL WAGES & OCCUPATIONAL CHOICE

4 ASSUMPTIONS ABOUT WORKERS Utility maximization Perfect worker information Perfect worker mobility Jobs have different non-pecuniary characteristics Individuals differ in preferences for non-pecuniary characteristics Definition Compensating wage differential Premium firms have to offer workers to compensate for working conditions Can have both positive and negative premium MARKET FOR NON-MONEY CHARACTERISTICS OF WORK IMPLICIT PRICE of non-pecuniary job characteristics Positive differential for negative characteristics Negative differential for positive characteristics One explanation why more than 1 wage rate in labor market

5 EMPLOYEE PERSPECTIVE TRADE-OFF BETWEEN EARNINGS & NEGATIVE JOB ATTRIBUTE Constant Utility Slope = Rate of exchange between wage & negative job aspect Diminishing marginal returns Preferences differ across individuals Employee Trade-off (good) Risk (bad) People differ More Risk Averse (good) Less Risk Averse Risk (bad)

6 EMPLOYER CONSIDERATIONS TRADE-OFF BETWEEN Cost of reducing negative aspects of job Cost of compensating employees to put up with those aspects Firm offer is bounded Upper bound: Competitive mkt. ->0 profits Lower bound: Need sufficient # workers Firms vary in ability to change aspects Firm Trade-off Below 0 profits Zero Profits Above 0 profits Risk Firms differ Expensive Inexpensive Risk

7 THE OFFER CURVE DEFINITION: Curve of all employers in market Wage/Job characteristics combinations from which workers can choose Market clearing implicit price Offer curve can shift over time Technological Change Change in worker preferences The Offer Curve Risk MATCH BETWEEN EMPLOYEES AND EMPLOYERS (Another Constrained Maximization Problem) WORKERS: Maximize utility s.t. offer constraint (highest wage for given risk or lowest risk for given wage) EMPLOYERS: Set wage high enough to attract enough but not too many THE MATCH: Utility maximized at tangency b/n utility & offer curves

8 Matching workers to employers Individual Workers Utility Market offer curve Risk INSIGHTS FROM COMPENSATING WAGE DIFFERENTIAL MODEL increase with risk (or any uniformly bad aspect), ceteris paribus Workers with strong preferences (aversion) for job aspect will work at firm that provides that most cheaply (reduces it at lowest cost) CWD allocates labor Source of equity in compensation

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