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Book Notes: “Principles of Microeconomics” - Part 6: Labor Markets (Mankiw)

This post is 6th in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).


Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)


Part 6: The Economics of Labor Markets

Chapter 18: The Markets for the Factors of Production

  • In 2015, the national income for the U.S. was $16T.

    • Workers earned 2/3 of this total in wages and benefits.
    • Landowners and capitalists earned 1/3 of this total from rent, profit and interest.
  • Supply and demand for labor, land and capital (the factors of production) determine the prices paid to workers, landowners and capital owners.

  • Factors of production: The inputs used to produce goods and services.

  • Factors markets differ from the markets for goods and services in on key way: Demand for a factor of production is a derived demand.

    • A firm’s demand for a factor of production is derived from its decision to supply a good in another market.
    • Example: The demand for computer programmers is linked to the production of computer software.
  • Labor is the most important factor of production (when measured by income).

18-1 The Demand for Labor

  • Labor is governed by the forces of supply and demand.

    • Labor differs from other markets because it is a derived demand.
    • To understand labor demand you must also understand the underlying goods that the labor is used to produce.
  • Example: How an apple producer decided the quantity of labor to demand.

    • Background: Firm owns an apple orchard. Each week the firm decides how many workers to hire to pick apples. Workers pick as many apples as they can. Firm sells the apples, pays the workers and keeps the remaining profit.

    • Assumptions:

      • Firm is a price taker: Firm is competitive both in the market for apples (in which firm is a seller) and in the market for apple pickers (in which the firm is a buyer).
      • Firm is profit-maximizing. Doesn’t care about how many apples are picked and how many workers are hired.
    • The firm production function reveals the relationship of inputs of production (apple pickers) to the outputs of production (apples).

      • For example: 1 worker picks 100 apples. 2 workers pick 180 apples, 3 workers pick 240 apples and 4 workers pick 280.
      • Marginal product of labor: The increase in the amount of output from an additional unit of labor. In the example above, the marginal product of the second worker is 80 apples. The marginal product of the third worker is 60 apples. The marginal product of the fourth worker is 40 apples.
      • Diminishing marginal product: The property whereby the marginal product of an input declines as the quantity of the input increases. In the example above, adding more workers does not result in a constant, linear increase of output.
    • Firm must then determine how much profit each worker yields:

      • Profit is total revenue minus total cost.
      • Profit from an additional worker is worker’s contribution to revenue minus the worker’s wage.
      • In the example above apples are priced at $10/apple and wages are $500/week.
      • Value of the marginal product: The marginal product of an input times the price of the output.
      • 3 workers yield $2400 in total revenue at a cost of $1500 for a profit of $900. If the farm hires 4 workers their total revenue is $2800 at a cost of $2000 for a profit of $800.
      • Optimal profit-maximizing decision is to hire 3 workers.
    • “A competitive, profit-maximizing firm hires workers up to the point at which the value of the marginal product of labor equals the wage.”

    • Causes of labor-demand curve shifts:

      • Output price: When the output price changes, the value of the marginal product changes.

        • Increased price: Raises the value of the marginal product which increases labor demand.
        • Decreased price: Reduces the value of the marginal product which decreases labor demand.
      • Technological change: Results in improved labor output (which changes the marginal product of labor).

        • Labor-saving technologies: Reduces the marginal product of labor (example: robots outpace their human counterparts in comparison). Reduces the demand for labor.
        • Labor augmenting technologies: Boosts marginal product of labor and increases labor demand.
        • The supply of other factors: The quantity of one factor of production can impact the marginal product of other factors. Example: Apple picker productivity is dependent on the availability of ladders (poor ladder availability with result in reduced apple picking output).

18-2 The Supply of Labor

  • Labor supply is a trade-off between work and leisure.

  • The labor-supply curve reflects how workers’ decisions about the labor-leisure tradeoff is affected by changes in the opportunity cost.

  • Upward-sloping labor supply curve: Increase in wages results in increased quantity of work supplied.

  • Causes for labor-supply curve shifts (assuming upward sloping curve):

    • Changes in tastes/attitudes: Big increases of women in the workforce since the 1950s due to changing social norms.
    • Changes in alternative opportunities: Individual labor markets are impacted by adjacent markets. Example: If wages for pear pickers increases, apple pickers may switch occupations.
    • Immigration: Results in more labor for the receiving country while labor is reduced in the country of origin.

18-3 Equilibrium in the Labor Market

  • Facts about wages in competitive labor markets:

    • Wages adjust to balance the supply and demand for labor.
    • The wage equals the value of the marginal product of labor.
  • Figure illustrating labor market in equilibrium (see below). In this case, the “price” is the wage. The quantity is the amount of labor.
(Image from Wikipedia.org)
  • “Any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount because these must always be equal.”
  • Example: Consider how immigration impacts the market for apple picking:

    • More workers shift the supply of labor to the right.
    • Quantity of labor now exceeds the quantity demanded.
    • Surplus labor forces downward pressure on apple picker wages.
    • Falling wages make it profitable for firms to hire more workers.
    • As number of workers rises in an apple orchard, the marginal product of a worker falls.
    • The result is that the value of the marginal product of labor and the wages paid are lower than they were before the influx of new workers.
  • The economy consists of many specific labor markets.

    • For example there might be an overall “fruit picking” market.
    • There are sub-markets within the fruit picking market: apple picking, pear picking, etc.
    • Immigration may lower wages in some labor markets but it may have an opposite effect for other labor markets.
  • General equilibrium effects: The linkages between various markets result in complex systems that go far beyond the obvious impacts of phenomena like immigration.

  • Shifts in price also impact labor demand:

    • Example: Apple prices rise.
    • Price increase does not raise the marginal product (e.g. apples picked) but it does increase the marginal value of the marginal product.
    • The price of apples rise and apple producers make greater profit and workers earn higher wages.
  • “Highly productive workers are highly paid, and less productive workers are less highly paid.”

18-4 The Other Factors of Production: Land and Capital

  • Capital: The stock of equipment and structures used to produce goods and services.

    • Example: In an apple farm, the capital stock includes: ladders used to pick the apples, trucks uses to transport the apples, buildings used to store the apples and even the trees used to grow the apples.
  • Two types of prices:

    • Purchase price: The price paid to own a factor of production indefinitely.
    • Rental price: The price paid to use a factor of production for a limited period of time.
  • Case study: The Black Death

    • How did the plague impact workers’ wages and landowners’ rents?
    • Bubonic plague wiped out 1/3 of the population in 14th century Europe.
    • Smaller supply of workers => rising marginal product (diminishing marginal product in reverse) causing wages to rise.
    • Smaller supply of workers impacts the market for land. Each additional unit of land produces less additional output (diminishing marginal product) causing rents to fall.
    • Historical results: Wages doubled and rents declined 50%.

18-5 Conclusion

  • Neoclassical theory of distribution:

    • The amount paid to each factor of production depends on a given factor’s marginal productivity.
    • The demand depends on a factor’s marginal productivity.
    • In equilibrium each factor earns the value of its marginal contribution.
  • This theory answers the question: “Why are computer programmers paid ore than gas station attendants?”

    • Computer programmers produce goods of greater market value than gas station attendants.
    • Consumers are willing to pay high prices for software (e.g. computer games, spreadsheets, etc.).
    • Consumers are willing to pay little to have their gas pumped and their windshield washed.

Chapter 19: Earnings and Discrimination

19-1 Some Determinants of Equilibrium Wages

  • Wages are only one job attribute that workers take into account when deciding what jobs to take.

  • The supply of labor for easy, fun, and safe jobs is higher than the supply of labor for hard, dull, and dangerous jobs.

  • Compensating differential: A difference in wages that arises to offset the non-monetary characteristics of different jobs.

  • Examples of compensating differentials:

    • Coal miners: Earn more than other workers with similar levels of education (due to the danger and long-term health implications of the work).
    • Night-shift workers: Earn more than comparable day-shift workers due to the undesirable time and requisite lifestyle changes.
    • Professors: Earn less than lawyers and doctors despite similar amounts of education.
  • Human capital: The accumulation of investments in people such as education and on-the-job training.

  • Highly educated workers have higher marginal products.

  • Skill-biased technological change: Changes that raise the demand for skilled-workers and reduce demand for unskilled labor. For example: computer programming skills are highly-valued because they result in greater worker productivity and output.

  • Wage variables:

    • Measurable variables: education/schooling, years of experience, job characteristics.
    • Unmeasurable variables: ability, effort and chance. These factors play important roles in wage variability but are less understood than the measurable variables.
  • The signaling theory of education: Posits that the main benefit of highly educated prospects to employers is that their college degrees signal ability. In other words “an action is being taken not for its intrinsic benefit but because the willingness to take that action conveys private information to someone observing it.”

  • “Superstars” (ultra-high wage earners) arise in markets with the following characteristics:

    • Every customer in the market wants to enjoy the good supplied by the best producer.
    • The good is produced with a technology that makes it possible for the best producer to supply every customer at low cost.
    • Examples: Movie-stars and popular athletes.
  • Situations for above-equilibrium wages:

    • Minimum-wage laws (a government-mandated price floor on wages).

    • Labor unions: A worker association that collectively bargains with firms on the topic of wages, benefits and working conditions.

      • Unions can threaten to withhold work through a strike (an organized withdrawal of labor).
      • Studies suggest that union workers earn 10-20% more than comparable non-union workers.
    • Efficiency wages: Above-equilibrium wages paid by firms to increase worker productivity, reduce worker turnover and boost worker morale/happiness.

19-2 The Economics of Discrimination

  • Discrimination: The offering of different opportunities to similar individuals who differ by race, ethnic group, sex, age, or other personal characteristics.

  • Other factors should be considered:

    • Human capital: Education, experience, quality of education.
    • Compensating differentials
  • “Because the differences in average wages among groups in part reflect differences in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labor market.”

  • “The profit motive is a strong force acting to eliminate discriminatory wage differentials, but there are limits to its corrective abilities.”

  • Two limiting factors to consider:

    • Customer preferences
    • Government policies
  • Example: An imaginary economy with blondes and brunettes.

    • Hypothetical restaurant owner discriminates against blondes when hiring waiters.
    • Blonde waiters earn lower wages than brunettes.
    • Competing restaurant can open with blonde waiters and charge lower prices. Customers that only care about the price and quality of their meals will patronize this restaurant.
    • Competing discriminatory restaurants will be forced to change their labor practices or face going out of business.
    • If discriminatory preference of the public is strong, the entrance of blonde restaurants will not eliminate the wage differential.
  • “Competitive markets contain a natural remedy for employer discrimination. The entry of firms that care only about profit tends to eliminate discriminatory wage differentials. These wage differentials persist in competitive markets only when customers are willing to pay to maintain the discriminatory practice or when the government mandates it.”

19-3 Conclusion

  • In competitive markets workers earn wages equal to the value of their marginal contribution to the production of goods and services.
  • Firms pay more for workers with high human capital (education, skills, experience, effort).
  • Firms play less to workers against whom customers discriminate because these workers contribute less to revenue.

Chapter 20: Income Inequality and Poverty

20-1 The Measurement of Inequality

  • Key questions about income distribution and inequality:

    • How much inequality is there in our society?
    • How many people live in poverty?
    • What problems arise in measuring the amount of inequality?
    • How often do people move between income classes?
  • Poverty rate: The percentage of the population whose family income falls below and absolute level called the poverty line.

  • Poverty line: An absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty.

  • In the United States:

    • Poverty is correlated with race.
    • Poverty is correlated with age. Children are more likely to be members of poor families.
    • Poverty is correlated with family composition: Families with single-mothers are more likely to be poor than families with married couples.
  • In-kind transfers: Transfers to the poor given in the form of goods and services rather than cash.

  • Life cycle: The regular pattern of income variation over a person’s life.

  • Permanent income: A person’s normal income.

  • Economic mobility: The movement of people between income classes.

20-2 The Political Philosophy of Redistributing Income

  • Utilitarianism

    • Proponents: English philosophers Jeremy Bentham (d. 1832) and John Stuart Mill (d. 1873).
    • Believes the government should choose policies that maximize the total utility of everyone in society.
    • Utility: A measure of happiness or satisfaction.
    • Example: “Imagine that Peter and Paul are the same, except that Peter earns $80,000 and Paul earns $20,000. In this case, taking a dollar from Peter to pay Paul will reduce Peter’s utility and raise Paul’s utility. But because of diminishing marginal utility, Peter’s utility falls by less than Paul’s utility rises. Thus, this redistribution of income raises total utility, which is the utilitarian’s objective.”
    • Utilitarians reject complete equalization of incomes.
  • Liberalism:

    • Proponent: John Rawls in his book A Theory of Justice (1971).
    • The political philosophy according to which the government should choose policies deemed just, as evaluated by an impartial observer behind a “veil of ignorance.”
    • Maximum criterion: The claim that the government should aim to maximize the well-being of the worst-off person in society.
    • Social insurance: Government policy aimed at protecting people against the risk of adverse events.
  • Libertarianism:

    • The political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income.
    • “The libertarian alternative to evaluating economic outcomes is to evaluate the process by which these outcomes arise. When the distribution of income is achieved unfairly…the government has the right and duty to remedy the problem. But as long as the process determining the distribution of income is just, the resulting distribution is fair, no matter how unequal.”
    • Libertarians believe the equality of opportunity is more important the equality of outcomes.

20-3 Policies to Reduce Poverty

  • Minimum-wage laws:

    • Advocates: Helps the working poor without any cost to the government.
    • Critics: Hurts those it intends to help. Raises the cost of labor and reduces the quantity of labor demanded. Results in higher unemployment. Workers who remain employed are better off, but those who might have been employed at a lower wage are worse off.
    • Effects are contingent on elasticity of labor demand.
  • Welfare:

    • Government programs that supplement the incomes of the needy.

      • Temporary Assistance for Needy Families (TANF): A program that assists families with children and no adult able to support the family.
      • Supplemental Security Income (SSI): Provides financial assistance to sick or disabled individuals.
    • Critics: Welfare programs create incentives for people to become “needy.”

  • Negative income tax:

    • A tax system that collects revenue from high-income households and gives subsidies to low-income households.

    • Example: Taxes owed = 1/3 of income - $10,000

      • Family earning $90,000 pays $20,000 in taxes.
      • Family earning $60,000 pays $10,000 in taxes.
      • Family earning $30,000 owes nothing.
      • Family earning $15,000 receives $5,000 from the government.
    • Critics argue that this incentivizes laziness and unemployment.

    • The Earned Income Tax Credit (EITC) functions like a negative income tax.

  • In-kind transfers:

    • Instead of direct cash payments, in-kind transfers provides goods and services (e.g. food stamps, housing, clothing).
    • Advocates state that this provides essentials/necessities to those in need.
    • Advocates of cash payments argue that in-kind transfers are inefficient and disrespectful.
  • Antipoverty programs and work incentives:

    • Unintended consequence of many welfare programs is that they create disincentives for working.
    • One solution is to “reduce benefits to poor families more gradually as their income rises.”
    • The downside to this approach is that managing, measuring and administering these types of programs is expensive. Phaseouts create greater eligibility and coverage as well.

20-4 Conclusion

  • Governments can sometimes improve market outcomes but the consensus on what that outcome should be is fiercely debated.

  • The economic principle of trade-offs should be considered as part of the debate about economic inequality:

    • Penalizing successful people and rewarding unsuccessful people reduces market incentives to succeed.
    • Trade-off is between efficiency and equality.


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