CHAPTER 16:

Labor Markets
Because the subject of labor demand was extensively treated in Chapter 11, the problems in this
chapter focus primarily on labor supply and on equilibrium in the labor market. Most of the labor
supply problems (16.1–16.3) start with the specification of a utility function and then ask
students to explore the labor supply behavior implied by the function. The primary focus of most
of the problems that concern labor market equilibrium is on monopsony and the marginal
expense concept (problems 16.5–16.7). Analytical problems are concerned with generalizing the
labor supply problems to consider risk, family labor supply, and intertemporal labor supply.

Comments on Problems

16.1 This problem is an algebraic example of labor supply that is based on a CobbDouglas
(constant budget shares) utility function. Part (b) shows in a simple context the work
disincentive effects of a lump-sum transfer. Three-fourths of the extra 4,000 is “spent” on
leisure which, at a price of $5 per hour, implies a 600-hour reduction in labor supply. Part
(c) then illustrates a positive labor supply response to a higher wage since the $3,000
spent on leisure will now only buy 300 hours. Notice that a change in the wage would not
affect the solution to part (a), because, in the absence of nonlabor income, the constant
share assumption assures that the individual will always choose to consume 6,000 hours
(=3/4 of 8,000) of leisure.

16.2 This problem uses the expenditure function approach to study labor supply. It shows why
income and substitution effects are precisely off-setting in the Cobb–Douglas case.

16.3 This problem is an application of labor supply theory to the case of means-tested income
transfer programs. The problem results in a kinked budget constraint. Reducing the
implicit tax rate on earnings (parts (f) and (g)) has an ambiguous effect on H since
income and substitution effects work in opposite directions.

16.4 This problem is a simple supply–demand example that asks students to compute various
equilibrium outcomes.

16.5 This problem is an illustration of marginal expense calculation. The problem also shows
that imposition of a minimum wage may actually raise employment in the monopsony
case.

16.6 This problem is an example of monopsonistic discrimination in hiring. The problem

shows that wages are lower for the less elastic supplier. The calculations are relatively
simple if students calculate marginal expense correctly.
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185 Chapter 16: Labor Markets

16.7 This is a bilateral monopoly problem for an input (here, pelts). Students may get confused
on what is required here, so they should be encouraged first to take an a priori graphical
approach and then try to add numbers to their graph. In that way, they can identify the
relevant intersections that require numerical solutions.

16.8 This problem is a numerical example of the union–employer game illustrated in Example
16.5.

Analytical Problems

16.9 Compensating wage differentials for risk. This problem develops the idea of a
certainty-equivalent wage rate.

16.10 Family labor supply. This problem introduces (in part (b)) the concept of “home
production.” The functional forms specified here are so general that this problem should
be regarded primarily as a descriptive one that provides students with a general
framework for discussing various possibilities.

16.11 A few results from demand theory. This problem shows how many problems in labor
supply theory can be addressed using demand theory concepts from Part 2 of the text.

16.12 Intertemporal labor supply. This problem is an introduction to some general concepts
in the theory of multiperiod labor supply. Because time has not yet been explicitly
introduced, however, the results pertain only to a situation with no discounting.

Solutions

16.1 a. With 8,000 hours/year, full income is $40,000. If 75 percent of this is

devoted to eisure, this $30,000 will “buy” 6,000 hours of leisure at $5 per hour. Hence,
work time will be 2000 hours.

b. Full income is now $44,000, so this person will devote $33,000 to leisure. This
will buy 6,600 hours of leisure, so labor supply will fall to 1,400 hours.

c. With the higher wage, full income is $84,000, $63,000 of which will be devoted
to leisure. Hence, leisure time is 6,300 hours and work time is 1,700 hours. In this
case, therefore the higher wage promotes a greater labor supply even in the
presence of nonlabor income.
Leisure = 6,300 hours; work = 1,700 hours. Hence, higher wage leads to
more labor supply. Note that in part (a) labor supply is perfectly inelastic at 2,000
hours.

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186 Chapter 16: Labor Markets

d. Labor supply is given by

0.75(8, 000w  4, 000) 3, 000
l 8, 000  2, 000  .
w w
The supply curve is therefore asymptotic to 2,000 hours.

16.2

a. Setting up the Lagrangian,

L c  wh  24w   (U  c h1  ),
yields the following first-order conditions for a minimum:
L c 1   c  1h1  0,
L h w   (1   )c h   0,
L  U  c h1  0.
Combining the first two equations gives the familiar result:
1 h

w (1   )c .
Manipulation of this condition and substitution into the utility function yields the
results that
h Uk   w  ,
c Uk 1  w1  ,
where

k .
1 
Substituting for expenditures gives
E c  wh  24w KUw1   24w,
 1 
where K k  k .

b. h c E w (1   )Uw  K  24.

c. l c 24  hc 48  (1   )Uw  K . Clearly, l c w  (1   )UKw   1  0 .

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187 Chapter 16: Labor Markets

d. The algebra is considerably simplified here by assuming  0.5, K 2 and using

a period of 1.0 rather than 24. With these simplifications,
l c
 0.5 1 0.5Uw 1.5
l 2  Uw
c
l 0.5  0.5nw . w .
Now, letting n  E in the expenditure function and solving for utility gives
U 0.5w0.5  0.5nw 0.5 .
For n 0, substitution yields
l c
0.25w 1 .
w
This is the substitution effect in the labor supply function.
To calculate the income effect, use the uncompensated function:
l 1
l (0.5  0.5nw 1 )( 0.5w 1 )  0.25w ,
n
when n 0. Hence, the substitution and income effects cancel out. (Note: In
working this problem, it is important not to impose the n 0 condition until after
taking all derivatives.)

16.3 a. Grant G 6000  0.75 I .

I G
0 6, 000
2, 000 4, 500
4, 000 3, 000

b. G 0 when I 6, 000 0.75 8, 000.

c. Assuming there are 8,000 hours in the year, budget constraint is

32,000 c  4h.

d. Budget constraint is now

32, 000  G 38, 000  0.75(32, 000  4h)
14, 000  3h
c  4h
for h 6, 000. Hence, the budget constraint is kinked at h 6, 000. Its
mathematical form is
14, 000 c  h for h 6, 000,
32, 000 c  4h for h  6, 000.
Leisure is inexpensive for h 6, 000 , expensive when h  6, 000.

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188 Chapter 16: Labor Markets

e.

f. New budget constraint is 23, 000 c  2h for h  5, 000.

g. Income and substitution effects of law change work in opposite directions (see
graph). Substitution effect favors more work (new budget constraint is steeper);
income effect favors less work (person has more income for h 5, 000 ).

16.4 Labor demand is L  50w  450, and labor supply is L 100w.

a. Setting labor demand equal to supply yields w 3, L 300.

b. With the subsidy, demand becomes L  50( w  s )  450. Setting w 4 and

equating supply and demand yields
400  50(4  s)  450,
implying s 3. Total cost of subsidy is 1,200.

c. With a minimum wage of w 4, labor demand = 250, labor supply = 400, and
unemployment = 150.
d.

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189 Chapter 16: Labor Markets

16.5 Given the supply curve for labor, marginal expense is computed as
l 80w,
 w l 80,
l2
 wl  ,
80
d ( wl ) l
 MEl   .
dl 40

a. For monopsonist, profit maximization required MEl MRPl :

l l
MEl  MRPl 10  ,
40 40
implying l 200 and w l 80 2.5.

b. For Carl, the marginal expense of labor now equals the minimum wage, and in
equilibrium the marginal expense of labor will equal the marginal revenue
product of labor.
l
MEl wmin 4 MRPi 10  ,
40
implying l 240. With this wage, supply will be 320. Hence there will be
unemployment of 80. But employment has increased from 200 to 240.

c.

d. Under perfect competition, a minimum wage means higher wages but fewer
workers employed. Under monopsony, a minimum wage may result in higher
wages and more workers employed.

16.6 First, look at the case of males:

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190 Chapter 16: Labor Markets

wm l m 9
2

3/2
lm
 w ml m 
3
0.5
lm
 MElm = = MRPl 10,
2
implies lm 400 and wm 20 / 3.
For females, the calculation is
l
wf  f
100
l 2f
 wf l f 
100
l
 MEl f  f 10,
50
l f 500 w 5.
implies and f The profit per hour on machinery equals
9, 000  5(500)  6.66(400) 3,833.
If same wage must be paid to men and women, w MRPl 10,
l lm  l f 900  1, 000 1,900.
Furthermore,
 1,900(10)  900(10)  1, 000(10) 0.

Since q 240 x  2 x , TR 5q 1, 200 x  10 x . MRP for pelts is

2 2
16.7 a.
dTR
1, 200  20 x.
dx
Production of pelts x = l , C wl 10 x , MC 20 x. Under competition, price
2

of pelts px MC 20 x and MRPx  px . Hence, 1, 200  20 x 20 x, implying

x 30 and px 600.

b. From Dan’s perspective, demand for pelts equals MRPx 1, 200  20 x  px .
Hence,
TR  p x x 1, 200 x  20 x 2 ,
implying
dTR
MR  1, 200  40 x.
dx
For profit maximization, use marginal revenue equals marginal cost:
1, 200  40 x 20 x,
implying x 20 and px 800.

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191 Chapter 16: Labor Markets

c. From UF’s perspective, the supply of pelts is reflected in the marginal cost curve
MC 20 x  px . Total cost is given by C  px x 20 x 2 .
MEx dC dx 40 x.

For profit maximization set MEx 40 x MRPx 1, 200  20 x, implying x 20
and px 400.

d. Both the monopolist and monopsonist agree on x 20, but they differ widely on
price to be paid (800 vs. 400). Bargaining will determine the result.

16.8 a. As in Example 16.5, this is solved by backward induction. In the

second stage of the game, the employer chooses l to maximize 10l  l  wl ,
2

implying l (10  w) 2. The union chooses w to maximize

10w  w2
wl  5w  0.5w2 ,
2
implying w 5, l 2.5, U 12.5,  6.25.
* * * *

b. With w 4 and l  4, we have U  16 and   8, which is Pareto-superior to

the contract in part (a).

c. For sustainability, one needs to focus on the employer who has incentive to cheat
if union chooses w 4 (profit maximizing l is 3, not 4). Since  (l 3) 9, the
condition for sustainability is
8 6.25 
9
1  1 
implying 1  2.75  , or   1 2.75 0.36.

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192 Chapter 16: Labor Markets

Analytical Problems

16.9 Compensating wage differentials for risk

Considering the first (riskless) job, U ( y ) 100 y  0.5 y and y wl with w 5 and
2

l 8 implies U (40) 3, 200. That is,

U Job 1 3, 200.
Considering the second (risky) job,
E (U Job 2 ) 100 E ( y )  0.5 E ( y 2 )
800 w  0.5  Var( y )  E ( y ) 2 
800 w  0.5  36 w2  64 w2 
800 w  50w2 .
Hence, to take the second job it must be the case that
800 w  50 w2 3, 200  ( w  8) 2 0
Thus, the required wage is w 8.

16.10 Family labor supply

h1 w2 h2 w1

a. and are both probably positive because of the income effect.

c1  f (h1 ), so, optimal choice would be to choose h1 so that f  w1. This would
b.
probably lead person 1 to work less in the market. That may in turn lead person 2
to choose a lower level of h2 on the assumption that h1 and h2 are substitutes in
the utility function. If they were complements, the effect could go the other way.
Clearly, one can greatly elaborate on this theory by working out all of the first-
order conditions and comparative statics results.

16.11 A few results from demand theory

a. Applying the envelope theorem to Equation 16.20,

V ( w, n) L
  (1  h) l ,
w w
V ( w, n) L
 .
n n
Hence,
V w
l .
V n
With the Cobb–Douglas,
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193 Chapter 16: Labor Markets


 n
V ( w, n)   ( w  n)    1   .
 w
Therefore,
1
V ( w, n)    1  n  n 
 ( w  n)   1     2 
w  w  w 
  (1  n w)  ( w  n)  1
   1

1
V ( w, n)  n
1
  ( w  n)   1  1  
 
n  w  w
  (1  n w)  ( w  n)  1 .
   1

Dividing the first equation by the second yields (after some manipulation)
n
l (1   )   .
w
This is the labor supply function given in Equation 16.24.

b. Using the logic of the development of the Slutsky equation, for any consumption
good
xi xi x
 h i .
w w U I
Hence, for any normal good, the income effect in this expression will be positive.
This positive effect will be reinforced for goods that are Hicksian complements
with labor (substitutes for leisure). The substitution effect will be negative,
however, for goods that are Hicksian substitutes for labor (complementary with
leisure), which is probably the case for most ordinary consumption goods. Hence,
it seems that in most cases the sign of this derivative will be ambiguous.

c. Marginal expense is the change in total labor costs for a change in hiring:
wl w  l w   1 
MEl  w  l w  1    w  1   .
l l  w l  
 el , w 
e ,
is likely to be positive, MEl  w. If l , w then MEl w.
el , w
Notice that since

16.12 Intertemporal labor supply

a. The Lagrangian expression for this utility-maximization problem is

L U (c1 , h1 )  E[U (c2 , h2 )]    W0  w1 (1  h1 )  c1  E (w2 )(1  h2 )  c2  .
Notice that here the budget constraint holds in expected value terms.

The first-order conditions for a maximum are

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194 Chapter 16: Labor Markets

L c1 U c1   0,
L h1 U h1   w1 0,
Lc2 E (U c2 )   0,
L h2 E (U h2 )   E ( w2 ) 0,
L  W0  w1 (1  h1 )  c1  E ( w2 )(1  h2 )  c2 0.
Combining the first two equations yields the familiar condition for a maximum:
Uh
MRS  1 w1.
U c1
An increase in initial wealth should increase both leisure and consumption
assuming they are normal goods.

b. The equation just says that second-period indirect utility is a function of the
wealth available at the start of that period and the second-period wage (which is
uncertain).

c. Because V is an optimized function we need to return to its original Lagrangian

expression to interpret derivatives. The indirect utility function arises from the
problem
max E[U (c2 , h2 )]
subject to
W * w2 (1  h2 )  c2 .
Because the second-period wage is random, the Lagrange multiplier associated
with W will also be random here (call this multiplier 2 ). But the solution to this
*

optimization problem will require

E (U c2 ) E (2 ).
Comparing this result to the original first-order conditions from part (a) shows
that
 E (2 ). The implicit value of wealth must be the same in the two periods
(in expected value) or there will be an incentive to move wealth from a period
where  is low to one where it is higher in expected value terms.

d. A certain increase in second-period wages is similar to an increase in initial

wealth. The first-period effects therefore should be to increase both consumption
and leisure. The effects on second-period labor supply are uncertain because
income and substitution effects work in opposite directions.

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