Labor economics.

Topic: Labor market equilibrium and policies.

Workers prefer to work when the wage is high, and firms prefer to hire when the wage
is low. Labor market equilibrium “balances out” the conflicting desires of workers and firms
and determines the wage and employment observed in the labor market.
If markets are competitive and if firms and workers are free to enter and leave these
markets, the equilibrium allocation of workers is efficient. The result is an example of Adam
Smith’s invisible hand theory, wherein labor market participants in search of their own
selfish goals attain an outcome that no one in the market consciously sought to achieve.

4-1 Equilibrium in a Single Competitive Market

Consequences of equilibrium in a single competitive labor
market

The supply curve gives the total number of employee-hours that agents in the
economy allocate at any given wage level; the demand curve gives the total number of
employee-hours firms demand at that wage. Equilibrium occurs when supply equals demand,
generating the competitive wage w* and employment E*.
Once the competitive wage level is determined, each firm hires workers up to the point
where the value of the marginal product of labor equals the competitive wage. The first firm
hires E1 workers, the second E2 and so on. The total number of workers hired by all the
firms in the industry must equal the market’s equilibrium employment level, E*.
Note: there is no unemployment in a competitive labor market. Persons who are not
working are also not looking for work at the going wage.
The concept of labor market equilibrium remains useful because it helps us understand
why wages and employment seem to go up or down in response to particular economic or
political events.

Efficiency
This figure also shows the benefits that accrue to the national economy as workers and firms
trade with each other in the labor market.
The total revenue accrued to the firm is adding up the value of marginal product of the
workers up to E*. This gives the value of the total product produced by all workers in a
competitive equilibrium. Area under demand curve gives the value of total product. Each
worker receives w*. P-producer surplus.
The supply curve gives the wage required to bribe additional workers into the labor market.
The height of the supply curve at a given point measures the value of the marginal worker’s
time in alternative uses. The difference between what the worker receives (w*) and the value
of the worker’s time outside the labor market gives the gains accruing to workers. Q- worker
surplus.
The total gains from trade accruing to the national economy is P+Q.

The competitive market maximizes the total gains from trade.

Example: at Eh, the “excess” workers have a value of marginal product that is less than their
value of time elsewhere.
Example: at El, the “missing” workers have a value of marginal product that exceeds their
value of time elsewhere, and their resources would be more efficiently used if they worked.

Efficient allocation is the allocation of persons to firms that maximizes the total gains from
trade in the labor market. A competitive equilibrium generates an efficient allocation of labor
resources.

4-2 Competitive Equilibrium across Labor Market

The economy typically consists of many labor markets, even for workers who have similar
skills. These labor markets might be differentiated by region, or by industry.

Suppose there are two regional markets in the economy, the North and the South. We assume
that the workers have similar skills so that they are perfect substitutes. The supply curves
are perfectly inelastic within each region. The equilibrium wage in the North exceeds the
equilibrium wage in the South.

Can this wage differential persist and represent a true competitive equilibrium?
No. This wage differential encourages southern workers to pack up and move north, where
they can earn higher wages and attain a higher level of utility. Employers in the North also
see the wage differential and realize they can do better by moving to the South. A firm can
make more money by hiring cheaper labor.

If workers can move across regions freely, the migration flow will shift the supply curves in
both regions:
-in the south, the supply curve would shift to the left as southern workers leave the region,
raising the southern wage;
-in the north, the supply curve would shift to the right as the southerners arrives, depressing
the wage.
If there were free entries and exits, then the national economy would eventually be
characterized by a single wage w*

Note: wages across the two labor markets also would be equalized if firms could freely enter
and exit labor market. When northern firms move to the South, the demand curve for
northern labor shifts to the left and lowers the northern wage.

As long as either workers or firms are free to enter and exit labor markets, therefore, a
competitive economy will be characterized by a single wage.

4-3 Policy Application: Payroll Taxes and Subsidies

We can easily illustrate the usefulness of the supply and demand framework by considering a
government policy that shifts the labor demand curve. In the United States, some
government programs are funded partly through a payroll tax assessed on employers: Social
Security, Medicare…
What happens to wage and employment when the government assesses a payroll tax on
employers?

Prior to the imposition of the tax, the labor demand is D0 and the supply is S. Equilibrium is
A.
Consider a very simply payroll tax: 1$ per employee-hour hired. The total cost of hiring an
hour of labor will be $11. Because employers are only willing to pay a total of w0 dollars to
hire the E0 workers, they are now only willing to pay a wage rate of w0-1 dollars to the
workers in order to hire E0 of them.
After the tax: D0->D1, new equilibrium point B. The amount the firms want to pay to their
workers shift down by $1 in order to cover the payroll tax.
Results: the number of workers hired declines to E1, the equilibrium wage rate- the wage
received by workers- falls to w1, but the total cost of hiring a worker rises to w+1.
It is worth noting that even though the legislation clearly states that employers must pay the
payroll tax, the labor market shifts part of the tax to the worker.

A tax assessed on Workers

It does not matter whether the tax is imposed on workers or firms. The impact of the
tax on wages and employment is the same regardless of how the legislation is written.
Suppose that the $1 tax on every hour of work had been assessed on workers rather than
employers.
The government now mandates that workers pay the government $1 for every hour they
work. Workers still want to make w0. In order to supply these many hours, the workers will
now want a payment of w0+1 dollars from employer. So, the supply curve will shift up by
one dollar to S1.
The equilibrium then shifts from A to B. At the new equilibrium, workers receive a wage
w1, and the total employment falls from E0 to E1.
Note: the actual after-tax wage of the worker falls from w0 to w1-1.

The true incidence of the payroll tax (that is, who pays what) has little to do with the
way the tax law is written or the way the tax is collected.

When will the Payroll tax be shifted completely to workers?

This is an extreme case.

Suppose that the tax is assessed on the firm and the supply curve of labor is perfectly
inelastic. E0 of workers are employed regardless of the wage.
As before, the payroll tax will shift the demand curve down by $1. Equilibrium wage: w0-
>w0-1. The more inelastic the supply curve, the greater the fraction of the payroll taxes
that workers end up paying.

Labor supply curve for men is inelastic, so it is not a surprise that most of the burden of
payroll taxes shifted to workers.

Deadweight Loss

Payroll taxes increase the cost of hiring a worker. These taxes reduce total employment-
regardless of whether the tax is imposed on workers or firms.
The after-tax equilibrium is, therefore, inefficient, because the number of workers
employed is not the number that maximizes the total gains from trade in the labor
market.
4-7a: total gains in the absence of taxes;
4-7b: total gains when the payroll taxes are imposed. Employment declines to E1, the cost of
hiring a worker rises to wtotal; and the worker’s rake-home pay falls to went.
P* is the producer surplus;
Q is the worker surplus;
T tax revenues accrued by the government.
The government will redistribute these tax revenues and someone will benefit from the
government’s expenditure.

Comparison of the two figures yields an important conclusion. The imposition of the payroll
tax reduces the total gains from trade.
DL-the deadweight loss (or excess burden) of the tax.
 The passage clarifies that deadweight loss is not the cost of enforcing or collecting the tax
(e.g., administrative expenses).
 Instead, it is the economic loss that results from fewer people being employed than in an
efficient, tax-free market.

Employment subsidies
Government subsidies are designed to encourage firms to hire more workers. An
employment subsidy lowers the cost of hiring for firms.

In the typical subsidy program, the government grants the firm a tax credit, say of $1, for
every person-hour it hires. Because the subsidy reduces the costs of hiring a person-hour by
$1, it shifts the demand curve by that amount. The new demand curve D1 gives the price the
firms are willing to pay to hire a particular number of workers after they take into account of
the employment subsidy.
Labor market equilibrium shifts from A to B. At the new equilibrium, there is more
employment. Also, subsidy increases the wage that workers actually receive (from w0 to
w1), and reduces the wage the firms actually have to pay out of their own pocket.

The labor market impact of these subsidies can be sizable and will obviously depend on the
elasticity of the labor supply and the labor demand.