Labour economics seeks to understand the functioning of the market for labour . Labour markets function through the interaction of workers and employers.Labour economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attemptsto understand the resulting pattern of wages, employment, and income.
It is an important subject because unemployment is a problem that affects the public most directly and severely. Fullemployment (or reduced unemployment) is a goal of many modern governments.
Two ways of analysing labour markets
There are two sides to labour economics. Labour economics can generally be seen as the application of microeconomic or macroeconomic techniques to the labour market. Microeconomic techniques study the role of individuals in thelabour market. Macroeconomic techniques look at the interrelations between the labour market, the goods market, the money market,and the foreign trade market. It looks at how these interactions influence macro variables such as employment levels,participation rates, aggregate income and Gross Domestic Product
The macroeconomics of labour markets
The labour force is defined as the number of people employed plus the number unemployed but seeking work. Theparticipation rate is the number of people in the labour force divided by the size of the adult population (orby the population of working age ).The unemployment level is defined as the labour forceminus the number of people currently employed. The unemployment rate is defined as the level of unemploymentdivided by the labour force. The employment rate is defined as the number of people currently employed dividedby the adult population (or by the population of working age). In these statistics , self-employed people are counted as employed.
Variables like employment level, unemployment level, labour force, and unfilled vacancies are called stockvariables because they measure a quantity at a point in time. They can be contrasted with flowvariables which measure a quantity over a duration of time. Changes in the labour force are due to flow variables suchas natural population growth, net immigration, new entrants, and retirements from the labour force. Changes in unemploymentdepend on: inflows made up of non-employed people starting to look for jobs and of employed people who lose their jobs and lookfor new ones; and outflows of people who find new employment and of people who stop looking for employment.
When looking at the overall macroeconomy, several types of unemployment have been identified, including:
The classical microeconomics of labour markets
Economists see the labour market as similar to any other market in that the forces of supply and demand jointly determine price (in this case the wage rate) and quantity (in this case thenumber of people employed).
However, the labour market differs from other markets (like the markets for goods or the money market) in several ways.Perhaps the most important of these differences is the function of supply and demand in setting price and quantity. In marketsfor goods, if the price is high there is a tendency in the long run for more goods to be produced until the demand is satisfied.With labour, overall supply cannot effectively be manufactured because people have a limited amount of time in the day, andpeople are not manufactured. A rise in overall wages will, in many situations, not result in more supply of labour: it may resultin less supply of labour as workers take more time off to spend their increased wages, or it may result in no change in supply.Within the overall labour market, particular segments are thought to be subject to more normal rules of supply and demand asworkers are likely to change job types in response to differing wage rates.
Many economists have thought that, in the absence of laws or organisations such as unions or large multinational corporations,labour markets can be close to perfectly competitive in the economic sense — that is, there are many workers and employersboth having perfect information about each other and there are no transaction costs. The competitive assumption leads to clearconclusions — workers earn their marginal product of labour.
Other economists focus on deviations from perfectly competitive labour markets. These include job search, training andgaining-of-experience costs to switch between job types, efficiency wage models and oligopsony / monopsonisticcompetition .
Neoclassical microeconomic model — Supply
Households are suppliers of labour. In microeconomics theory, people are assumed rational and seeking to maximize their utility function . In this labour market model, their utilityfunction is determined by the choice between income and leisure. However, they are constrained by the waking hours available tothem.
Let w denote hourly wage. Let k denote total waking hours. Let L denote working hours. Let π denote other incomes or benefits. Let A denote leisure hours.
The utility function and budget constraint can be expressed asfollowing:
This can be shown in a diagram (below) that illustrates the trade-off between allocating your time between leisure activitiesand income generating activities. The linear constraint line indicates that there are only 24 hours in a day, and individualsmust choose how much of this time to allocate to leisure activities and how much to working. (If multiple days are beingconsidered the maximum number of hours that could be allocated towards leisure or work is about 16 — Everyone has to sleepeventually!) This allocation decision is informed by the curved indifference curve labeled IC. The curve indicates the combinations of leisure and work that will givethe individual a specific level of utility. The point where the highest indifference curve is just tangent to the constraint line(point A), illustrates the short-run equilibrium for this supplier of labour services.
The Income/Leisure trade-off in the short run
If the preference for consumption is measured by the value of income obtained, rather than work hours, this diagram can beused to show a variety of interesting effects. This is because the slope of the budget constraint becomes the wage rate. Thepoint of optimization (point A) reflects the equivalency between the wage rate and the marginal rate of substitution , leisure for income(the slope of the indifference curve). Because the marginal rate of substitution, leisure for income, is also the ratio of themarginal utility of leisure (MUL) to the marginal utility of income (MUY), one can conclude:
Effects of a wage increase
If wages increase, this individual's constraint line pivots up from X,Y1 to X,Y2. He/she can nowpurchase more goods and services. His/her utility will increase from point A on IC1 to point B on IC2. Tounderstand what effect this might have on the decision of how many hours to work, you must look at the income effect and substitution effect .
The wage increase shown in the previous diagram can be decompiled into two separate effects. The pure income effect is shownas the movement from point A to point C in the next diagram. Consumption increases from YA to YC and— assuming leisure is a normal good — leisure time increases fromXA to XC (employment time decreases by the same amount; XA to XC).
The Income and Substitution effects of a wage increase
But that is only part of the picture. As the wage rate rises, the worker will substitute work hours for leisure hours, thatis, will work more hours to take advantage of the higher wage rate, or in other words substitute away from leisure because of itshigher opportunity cost . This substitution effect is represented bythe shift from point C to point B. The net impact of these two effects is shown by the shift from point A to point B. Therelative magnitude of the two effects depends on the circumstances. In some cases the substitution effect is greater than theincome effect (in which case more time will be allocated to working), but in other cases the income effect will be greater thanthe substitution effect (in which case less time is allocated to employment activities). The intuition behind this latter case isthat the worker has reached the point where his marginal utility ofleisure outweighs his marginal utility of income. To put it in less formal (and less accurate) terms: there is no point inearning more money if you don't have the time to spend it.
The Labour Supply curve
If the substitution effect is greater than the income effect, the supply of labour curve (diagram to the left) will slopeupwards to the right, as it does at point E for example. This individual will continue to increase his supply of labour servicesas the wage rate increases up to point F where he is working HF hours (each period of time). Beyond this point he willstart to reduce the amount of labour hours he supplies (for example at point G he has reduced his work hours to HG).Where the supply curve is sloping upwards to the right (positive wage elasticity of labour supply), the substitution effect isgreater than the income effect. Where it slopes upwards to the left (negative elasticity), the income effect is greater than thesubstitution effect. The direction of slope may change more than once for some individuals, and the labour supply curve is likelyto be different for different individuals.
Other variables that affect this decision include taxation, welfare, and work environment.
Neoclassical microeconomic model — Demand
This article has examined the labour supply curve which illustrates at every wage rate the maximum quantity of hours a workerwill be willing to supply to the economy per period of time. Economists also need to know the maximum quantity of hours anemployer will demand at every wage rate. To understand the quantity of hours demanded per period of time it is necessary to lookat product production. That is, labour demand is a derived demand: it is derived from the output levels in the goods market.
A firm's labour demand is based on its marginal physical product of labour (MPP). This is defined as the additional output (orphysical product) that results from an increase of one unit of labour (or from an infinitesimally small increase in labour). Ifyou are not familiar with these concepts, you might want to look at production theory basics before continuing with this article.
The Marginal Physical Product of Labour
In most industries, and over the relevant range of outputs, the marginal physical product of labour is declining. That is, asmore and more units of labour are employed, their additional output begins to decline. This is reflected by the slope of theMPPL curve in the diagram to the right. If the marginal physical product of labour is multiplied by the value of theoutput that it produces, we obtain the Value of marginal physical product of labour:
The value of marginal physical product of labour (VMPPL) is the value of the additional output produced by anadditional unit of labour. This is illustrated in the diagram by the VMPPL curve that is above theMPPL.
In competitive industries, the VMPPL is in identity with the marginal revenue product of labour (MRPL).This is because in competitive markets price is equal to marginal revenue, and marginal revenue product is defined as themarginal physical product times the marginal revenue from the output (MRP = MPP * MR).
A Firm's Labour Demand in the Short Run
The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. Incompetitive markets, a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginalresource cost of labour (W = SL = MFCL). In imperfect markets, the diagram would have to be adjustedbecause MFCL would then be equal to the wage rate divided by marginal costs. Because optimum resource allocationrequires that marginal factor costs equal marginal revenue product, this firm would demand L units of labour as shown in thediagram.
Neoclassical microeconomic model — Equilibrium
The demand for labour of this firm can be summed with the demand for labour of all other firms in the economy to obtain theaggregate demand for labour. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtainthe aggregate supply of labour. These supply and demand curvescan be analysed in the same way as any other industry demand and supply curves to determine equilibrium wage and employmentlevels.
Since the 1970s some attention has shifted to the information characteristics of the labour market.
In the classical model it is assumed that both sides know how much work effort and marginal product the employeecontributes.
In many real-life situations this is far from the case. The firm does not necessarily know how hard a worker is working or howproductive they are. This provides an incentive for workers to shirk from providingtheir full effort — since it is difficult for the employer to identify the hard-working and the shirking employees, thereis no incentive to work hard and productivity falls overall.
The methods used to overcome this type of problem have been studied by modern labour economists.
One solution used recently ( stock options ) grants employees the chance to benefit directly from the firm's success. However, thissolution has attracted criticism as executives with large stock option packages have been suspected of acting to over-inflateshare values to the detriment of the long-run welfare of the firm.
Criticisms of labour economics
One critique of standard economic analysis of labor markets is that it does not account for the importance of social networks in the employment process. This view holds that personalconnections are key for both workers and employees. Hence, employees are more likely to apply for jobs where they have a personalconnection, and are more likely to be hired if they apply.
More generally sociologists and political economists claim that labour economics tends to lose sight of the complexity ofindividual employment decisions. These decisions, particularly on the supply side, are often loaded with considerable emotionalbaggage and a purely numerical analysis can miss important dimensions of the process.
Also missing from most labour market analysis is the role of unpaid labour. Even though this type of labour is unpaid it cannevertheless play an important part in society. The most dramatic example is child raising. Unpaid work is typically ignoredbecause it is difficult to measure and there is no agreed upon method of incorporating it into standard analysis. When the unpaidlabour variable is ignored, the model’s conclusions might be biased.
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