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Labor economicsCHAPTER 1: INTRODUCTION TO LABOR ECONOMICS
• Labor economics studies how labor markets work. The main actors in labor markets are (1)
workers, (2) firms and (3) governments (governments can influence the decisions of workers
and firms by taxes, subsidies or regulation).
• Labor economics helps us understand many social problems. Some of the issues examined by
labor economists include:
1. Why did the labor force participation of women rise steadily throughout the 20 th
century in many industrialized countries?
2. What is the impact of immigration on the wages of native workers?
3. Do minimum wages increase the unemployment rate?
4. What is the impact of trade unions on wages and inequality?
5. What is the effect of generous unemployment benefits on the unemployment rate?
6. Why has wage inequality been increasing in recent decades?
7. What would be the effect of a working time reduction to 35 hours per week?
8. To what extent are some groups of workers exploited by employers?
Case: the Alaskan labor market
• In 1968 huge oil reserves were discovered in Alaska. Oil companies joined forces to construct
the Trans-Alaska Pipeline System between 1974 and 1977 many workers needed but only
temporary. The project substantially increased labor demand in Alaska (temporarily):
50,000 workers, i.e. the largest private construction project at that time.
After completion only a small maintenance crew remained employed.
• Why do we need a theory? A valid theory can explain and predict how these shifts in the
labor market in Alaska affect wages or other things a policymaker needs to consider before
approving such a project.
Theories and models:
– A theory is a simplified description or story of how phenomena are causally
connected. We use theories all the time. For example, if your TV does not work
(black screen) and you solve the problem by plugging in its cable, then you relied on
a theory about how you believe a TV works (“electricity causes my TV to work”).
– A model is a formal or mathematical presentation of a theory.
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,Labor economics
The supply and demand model of the labor market
Consider the labor market for engineers in Alaska:
Price on vertical axis and quantity on horizontal axis.
Supply:
• The labor supply curve gives the
number of persons who are willing
to work as an engineer at a given wage.
• We assume that workers have the
desire to maximize their well-being, so
they tend to supply more time to those
activities that have a higher payoff.
In that case, the supply curve is upward
sloping because the higher is the wage,
the more workers will choose to be engineers.
• When working with the supply and demand
model, distinguish between:
‘A change in the quantity supplied’ is a movement along the supply curve if the wage changes
and everything else remains constant.
‘A change in supply’ is a change/shift in the supply curve itself, e.g. because workers prefer to
have more leisure time.
Demand:
• The labor demand curve gives the
number of engineers that firms are
willing to hire at a given wage.
• We assume that firms wish to maximize
their profits.
This implies that employers hire fewer
workers when labor is expensive because
the higher is the wage, the higher are
product prices and the lower are product
demand and the demand for engineers.
So the demand curve is downward sloping.
• When working with the supply and demand model, distinguish between:
‘A change in the quantity demanded’ is a movement along the demand curve if the wage changes
and everything else remains constant.
‘A change in demand’ is a change/shift in the demand curve itself, e.g. because the demand for
the products made by the workers increases.
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, Labor economics
Supply and Demand:
• Workers (supply) and firms (demand) enter the labor market with conflicting interests: many workers
are willing to supply their services when wages are high, but few firms are willing to hire them.
• As workers search for jobs and firms search for workers, the conflict is resolved and the labor market
reaches an equilibrium:
If the wage is above the equilibrium, then more workers will be looking for work than firms want
to hire. The search for a job by workers will drive down wages as they compete for jobs.
If the wage is below the equilibrium, then more workers are demanded by firms than there are
workers willing to work. The search for workers by firms will drive up wages because firms compete
for the few available engineers.
What is a good model?
Many of the models we will discuss in class are debatable and sometimes controversial. So let us
think about what makes a model good and valid:
• Models rely on assumptions, but keep in mind that all theories (including theories from other
fields than economics) rest on assumptions. The advantage of an economic model is that it
makes the underlying assumptions explicit.
• Economists are often criticized for developing models that are “too simple”.
For example, you might (rightly) argue that there are many other reasons why people decide to
work as an engineer except for wages.
Economists answer that the best theory is a theory that is simple and that explains a lot. It is very
easy to construct “more complex” models, using lots of assumptions that bring the model closer to
reality, but this would not increase our understanding.
However, if you claim that a particular economic model, or its assumptions, is not realistic (does
not explain anything), then that is a valid criticism.
• A good model has realistic assumptions, is relatively simple and has testable implications. If
empirical research falsifies the implications of a model, then the model is clearly wrong and a
new model, based on better assumptions, is needed.
The debate about the supply and demand model
• The supply and demand model of the labor market is criticized by political economists.
Political economy is an approach to economics, which differs from neoclassical economics in
its focus on:
conflicts between interest groups (e.g. workers and employers);
the role of power in economic relationships (e.g. if an employer can make a worker act in a way
that is to the employer’s advantage);
the study of capitalism as an economic system;
the need for economists to study history.
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, Labor economics
• Political economists criticize the supply and demand model for being a-historical and for
presenting the labor market and wage labor as a natural state (something that never
changes), while wage labor has developed historically and many other forms of labor
relations have existed both in the past and today, for example:
Slavery: these workers have no choice to “supply” more or less labor because they are bought
and sold in slave markets.
Care work in households: no wages are paid in this work relation.
Work in cooperatives: these organizations do not aim to maximize profits.
Case: the Alaskan labor market application:
• Let’s apply the supply and demand model to the Alaskan labor market: the construction
project leads to a temporary change in labor demand.
• Before the labor demand shock
(period 0): equilibrium in w0 and E0
After the shock (period 1):
equilibrium w1 and E1
• So the supply and demand model
predicts that wages and employment
increase due to the demand shock.
These are testable implications.
• Once the project ends, demand would fall
back and wages would go down again.
What do the data tell us about the Alaskan labor market?
Both wages and employment increased temporarily, which is in line with the predictions from the
supply and demand theory of the labor market.
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