Labor Economics (Econ 3101)

COURSE CONTENT
 Unit 1: Introduction
 Unit 2: Labour Supply Theory
 Unit 3: Labour Demand Theory
 Unit 4: Wage Determination and Compensating Wage
Differentials
 Unit 5: Unions and the Labor Market
 Unit 6: Investment in Human Capital and Manpower
planning
 Unit 7: Labour Policy
 Unit8: The Working of Labour Market and Employment
Problems in Developing Countries
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 CHAPTER ONE: INTRODUCTION TO LAB.ECON

 Outline of this chapter:

1. The meaning of Labor economics and issues discussed in
labor economics
2. The linkages between labor market and the economy
3. Labor economics and its evolution
4. Labor and its peculiarities as factor (input of production)

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 When the concept of labor economics emerges?
 The classical economist, Adam Smith, known as father of Economics,
pointed out the centrality of labor to the economy and the special
characteristics of labor as a participant in the economy in his book of
“The Wealth of Nations” (1776). Smith, centrally discussed the creation and
distribution of wealth of nation across different factors of production like
labor, land, capital etc, and labor factor has indispensable role in the
creation and distribution of wealth.
 The development of labor economics was not completed within a
century but as a distinct discipline, Labor economics today is not
more than quite a century old.
 After, the emergence of Labor Economics as a specialized field,
the founders of the new discipline were so strongly oriented to other
interests like: unions and unionism, labor history, collective bargaining,
social and protective labor legislation and industrial disputes, so that the
older theories of value and distribution were destined to occupy a
subordinate place.
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 Cont. …
 Even after the emergence of specialized of labor economics,
the topics such as wage and employment theory were
typically considered to be a part of general economics till
1920’s.
 The specialized study of wages, labor markets, and institutions
did not begin to occupy a prominent position in the field until
the later 1920’s.
 Firmly, Labor economics established as an area of theoretical
and empirical inquiry in the main stream of economics.
 The tools that labor economists use to explain and investigate
economic phenomenon display the same theoretical rigor
and require application of the same degree of econometric
expertise as other major areas of the subject.

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 In short, the old study of labor economics was highly descriptive,
emphasizing historical developments, facts, institutions, and
legal considerations. But, Now, Labor Economics increasingly has
become applied micro and macro theory.
 What is labor economics today?
 Labor Economics is the study of the market in which labor
services are exchanged for wages.
 It studies how labor markets work, which refers to the study of the
workings and outcomes of the market for labor.
 It seeks to understand the functioning and dynamics of the markets
for wage labor. Labor markets function through the interaction of
workers and employers.

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 Labor economics looks at the suppliers of labor services
(workers), the demands of labor services (employers), and
attempts to understand the resulting pattern of wages,
employment, and income.
 Labor economics is a form of economic philosophy that
examines the factors involved in labor market. The field
of labor economics is quite wide; b/c the analysis of
the labor market may include not only economic considerations
but also sociological, psychological, and statistical issues as well.
 For example, some of the issues explored
through labor economics include the influences of education and
social dynamics on labor, relationships between the labor
force and employers, and wages.
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 More specifically:
 Labor Economics is primarily concerned with the behavior of
employers and employees in response to the general
incentives of wages, prices, profits, and non pecuniary
aspects of the employment relationship ( such as work
environment, risk of injury, personality of managers, flexibility
of work hours etc ).
 It examines:
The organization, functioning and outcomes of labor markets
The decision of prospective and present labor market
participants and
The public policies relating to employment and payment of
labor resources.
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 cont. …
Economics vs labor Economics
 Economics is concerned with the general question of
resource allocation and the determination of prices and
levels of production in the economy whereas, Labor
economics focuses on one particular aspect of this
process, the determination of wages and employment in
the labor market and the resulting distribution of income
among individuals and households.
 The scope and coverage of general economics is all
inclusive and too wider than that of labor economics.

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 The meaning of Labor economics and issues discussed in labor economics
 What are the focus area of labor Economics as a policy issues?
The policy issues examined by modern labor economics include
1. What is the impact of immigration on the wage and employment
opportunities of native-born workers?
2. Do minimum wages increase the unemployment rate of less-skilled
workers?
3. What is the impact of occupational safety and health regulations on
employment and earnings?
4. Are government subsidies of investments in human capital an effective
way to improve the economic well-being of disadvantaged workers?
5. What is the impact of affirmative action programs on the earnings of
women and minorities and on the number of women and minorities that
firms hire?
6. What is the economic impact of unions, both on their members and on
the rest of the economy?
7. Do generous unemployment insurance benefits lengthen the duration of
spells of unemployment?
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 1.2. The linkage between Labor market and the economy
 The relationship b/n labor market and a given economy explained
taking in to account operation of markets.
1.Goods (product)market: is the place where final goods and
services are observably traded.
 A market exists whenever there is a good or services for which
there are buyers (demanders) and sellers (suppliers) who engage
in mutual exchange or trade of the item.
 This exchange or trade is typically accomplished when there is a
common agreement at the price per unit that the buyer must pay to
the seller.

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 Cont. …
2. Labor(Factor) market:
 Labor is a factor of production which is owned by individual
households and, in effect, rented to business firms for a
period of time to be combined with other factor inputs such
as land and capital to produce good(s) or services.
 Labor is traded in what economists call a factor market,
just as the other factors of production such as land and
capital.
How the labor and product markets are interacted?

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 Cont. …
 Let, in the simplified economy there are two sets of economic agents,
households (the left hand box) and business firms (the right-hand
box).
Households are:
owner of inputs (particularly, labor)
Buyers of goods & services
Goal is to maximize utility
Business firm are:
 Producers of goods & services
 Buyers of inputs
 Goal is to maximize profit
 The goal of the business firm is to make a profit, and to do so they
produce goods and services to be sold in the product market. The
interaction of demand and supply in the product market gives rise to an
equilibrium price (P1) and quantity (Q1). The lower half of figure 1.1
shows how purchase of labor by firms and sales of labor by individual
household members interact in the labor market to determine the level of
wages and employment in the economy.
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 Cont. …
 To produce goods and services demanded by the households,
firms must obtain sufficient amounts of land, capital, and
labor. The desires by firms to supply goods and services in
the product market thus gives rise to a demand for workers in
the labor market, represented by the labor demand curve (DL).
 Similarly, for households to purchase goods and services they
desires, individual household members should work in order to
earn incomes.
 The demand for goods and services by households thus
gives rise to a supply of labor to firms, represented by the labor
supply curve SL. As in the product market, the interaction of
demand and supply in the labor market determines the wage rate
(W1) and the level of employment (L1).
 The household sector gives rise to a demand for goods (DG) in
the product market and supply of labor (SL) in the labor market.
 The business sector gives rise to a supply of goods (SG) and a
13 demand for labor (DL).
  A circular flow model of the Economy
 The interaction of demand and supply in the product market determines the level of
prices and production (P1, Q1); the interaction of demand and supply in the labor market
determines the level of wages and employment (W1, L1).

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Summary: labor market is-
 Labor market is the market where labor services are
exchanged
 In labor market, the price of labor services is called the wage
rate
 In labor market, quantity can be measured in various units
(hours, weeks, full-time workers)
 How is the labor market different?
 In most product markets the individuals that participate in the
market are the buyer/demander of goods and services but in
the labor market, individuals are the seller/supplier of labor
services
 Firms are the demanders in the labor market – demand for
labor is derived from the production decision of firms
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  Labor economics and evolution of schools of thought

What and which factor mainly determine the labor

market outcomes?
There are three main forces which affects the labor
market outcomes.
Market forces
Institutional forces
Sociological forces
Which is best?
 Most economists would readily agree that each of the
market, institutional, and sociological forces has some
role in shaping labor market outcomes.

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 Cont. …
 There is, nevertheless considerable debate and
disagreement over the relative importance of each
force, and how these forces work to bring about
specific labor market outcomes.
 These everlasting debate produces two distinct
schools of thought or paradigms in labor economics that
have compete back and forth over the years for
dominance in the field. Neoclassical vs institutional
thought.
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 Cont. …
1.The Neoclassical school of labor economics :
 The neoclassical school of labor economics is distinctive in
terms of both its theoretical framework and its
methodological approach to research.
 With respect to theory, the Neoclassical school gives
primary attention to the operation of markets and how
market forces determine wages & the allocation of
labor.
 To highlight the role of market forces, factors such as:
o The nature of legal and business institutions
All these did not affect
o Sociological considerations of culture and class
labor market outcomes
o The distribution of property and wealth, and
o The pattern of tastes and preferences are generally abstracted from or
treated as a given in the theory.
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 Cont. …
 The neoclassical theory of the labor market has two important
parts that heavily influence the conclusions and predictions
derived from the theory. Nature of human behavior and nature &
operation of markets
1. Regarding to the nature of human behavior, they assumed that:
1st. Individuals seek to maximize their level of well-being,
always striving/planning for the best or optimal outcome,
given the constraints they face.
2nd. Human beings have the cognitive ability to exercise rational
choice. This implies that the human brain is powerful enough
to calculate the value of alternative outcomes and rank
them in a consistent manner so that the optimal outcome
can be chosen.
3rd. Human beings are individualists in that behavior and
preferences are largely independent of what others can do
or think outside of the family.
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 Cont. …
2. Regarding to the nature and operation of markets, they assumed
that :
1st. The labor market has certain unique features, they do not
perceive theses differences to prohibited analyzing the labor
market with the same theoretical model used to study other
product and factor market.
2nd. The labor market is highly competitive, having a large
number of buyers and sellers and allowing relatively easy entry
into and exit from the market. The importance of these
assumptions is that they ensure that demand and supply determine
a stable equilibrium, that impersonal market forces are the
major determinants of wage and the distribution of labor and that
market outcomes result in an efficient allocation of resources.

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 Cont. …
 With respect to methodological approach, neoclassical economics
heavily reliance on:
1st. The deductive reasoning to derive theoretical predictions and
testable hypotheses. Deductive reasoning is the logic that progresses from
the general to the specific aspects. The word methodology means the
methods and processes by which economists seek to explain real-world
behavior. Its benefits:
1. It given only a few rather general assumptions, and possible to derive a
very elegant/graceful and sophisticated model of labor market behavior.
Its drawback:
1. The model and its predictions may be seriously in error if the assumptions
do not accord with real-world labor markets.
2nd. The marginal decision rules. Given that the goal of individuals is to
maximize some objective such as profits or utility, the “golden rule” is
always the same: whatever the activity, continue to do more of its as long as
the marginal increase in benefit exceeds the marginal increase in
21 cost: when the two become equal, the optimal amount has been reached.
 Cont. …
2. The institutional school of labor economics
 Institutional schools of labor economics states represent the
influence of various organizations such as unions, governments, and
corporations on the pricing and distribution of labor.
 Similar to neoclassical theory of the labor market, the theory of
institutional school of thought has two important emphases that
heavily influence the conclusions and predictions derived from the
theory. :
1st. Regarding to the human behavior:
A. Institutionalist rejects the Neoclassical rational actor model, and
deny that people maximize in pursuit of their economic
objectives, believing in an alternative theory of motivation known
as satisficing.
 Satisficing means that an individual pursues a goal only until he or
she reaches a minimum acceptable or satisfactory level. Rather than
strive for the optimal outcome, people desires for the outcome that
they regard as good enough, even if it is not the best they could do.
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 Cont. …
B. Institutionalists also believe that people’s are less
rational and consistent than what the rational actor
model presumes.
 The major problem as they see it, is that the human brain
is too limited, and in some cases too clouded by
emotions, to assimilate all the data and to make all
the complex calculations that are required to arrive at
optimal and consistent choices. Nobel laureate and Herbert
Simon calls this feature of human decision making
bounded rationality.

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 Cont…..
C. Finally, institutionalists also place great stress on two aspects of
preferences.
 The first, is that people’s preferences or tastes are
interdependent; what one person or group does has a
large influence on the behavior and preferences of others. As
one example, Institutionalists place considerable emphasis on
the role of equity or “fairness’’ as a determinant of human
behavior.
 The second aspect of preferences emphasized by
institutionalists is that preferences are not exogenous or a
“given,’’ but are Endogenous, meaning that they are shaped
by and changed with the economic system. The assumption
that people satisfice rather than maximize
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 Cont. …
2nd Regarding to the structure and operation of labor markets:
 According to institutionalists:
1. Institutional forces, such as internal labor markets and unions,
and sociological factors, such as class and discrimination,
segment or stratify the labor market into noncompeting groups, all
these preventing the free flow of labor from one sector to another.
2. They do not believe that market forces work as efficiently or
strongly as neoclassical economists maintain.
3. They give more weight to the importance of market
imperfections such as rigid wages, persistent unemployment,
barriers to labor mobility, and poor information.
4. They give a large role to the independent influence of
unions, corporations, discrimination, and custom in the process of
wage determination than do neoclassical economists.

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 Cont. ...
 The methodological approach of institutional labor
economists reliance in a different way than their neoclassical
counterparts. Institutionalists:
1. They prefer a case-study, inductive approach to research, believing
that it allows the researcher to see how the labor market ‘’really” works.
2. They claim that the marginal decision rules of neoclassical theory often
unrealistically describe how decisions are actually made. In their view,
decisions are more often made on the basis of average values rather
than marginal values. Why? Reasons are
1st. According to institutionalists, organizations such as unions typically
make policy decisions on the basis of a majority vote of the
membership instead of some type of marginal calculation of benefits
and cost.
2nd.The standard accounting data available to firms provides ready
information on average cost, average output per worker, and so on,
but very little information on the marginal value of such variables.
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  Labor market process and outcomes
 There is a useful distinction between labor market outcomes
and the labor market process. Labor market outcomes are the
observed events, behavior, or developments in the labor market
that we are trying to understand. The outcome represent the end-
product or final result of the operation of the labor market.
 There are different types of labor market outcomes like:
 The changing level and composition of labor supply
 The changing level and composition of labor demand
 The structure of earnings (average hourly earnings, weekly
earnings, annual earnings or lifetime earnings, etc)
 Labor-management relations and collective bargaining potential
 Changes in the level and composition of unemployment

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 Cont. …
 Labor market process: to understand the cause of the outcomes,
however, it is necessary to understand the process that gave rise to
them, that is, the mechanics of how the labor market works.
 What are the causes for labour market outcomes discussed in the
above?
 The labor market process involves three broad forces that together
determine each of the outcomes. These are, respectively, market forces,
institutional forces, and sociological forces.
1. Market forces –the first process to consider in the determination of
the price and allocation of labor is the market forces of supply and
demand in the labor market.

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 Cont. …
While a number of important non-economic factors
influence the pricing and distribution of labor, most
economists would agree that the interaction of the market
forces of supply and demand in the labor market is the single
most important determinants of labor market outcomes.
Example
 Increase in labor demand shifts the labor demand curve and
raise the wage rate
 Increase in labor supply shifts the supply curve to the right
and then decline the wage rate

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 Cont. …
2. Institutional forces- institutional forces represent the
influence of various organizations such as unions, governments,
and corporations on the pricing and distribution of labor.
Institutions affect labor outcomes in two different ways.
 First, they fragment or” balkanize” the labor market into a
number of segmented, loosely connected sub-markets.
 Second, institutions introduce structure, artificial boundaries,
and rigidities into the labor market. E.g. A firm invites internal
and external labor market. This segmentation has a
boundary between two types of labor market, which is not
governed by competition, and free market forces.

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 Cont. …
3. Sociological forces- the third determinants of labor market
outcomes are sociological forces, which represent the influence
of social groups and norms on the determination of wage
and the allocation of labor. Important factors include family
background, class, culture, discrimination and custom. All these
create non-competing group. They also affect the supply of labor,
the types of job that the individual prefers, etc.
 Some individuals or group may be discriminated
 A few types of jobs may be preferred by many workers

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  Unique characteristics of labor market
 The labor market differs from product markets in its structure or
characteristics in several ways. These differences in turn have a large
impact on both the theory and the actual operation of the labor market.
1. On the supply side: inseparability of labor service or labor is
embodied in the seller
 Labor service can only be rented. Workers themselves cannot be bought
and sold. Labor service cannot be separated from workers.
 Labor market distinguished from all other markets in the way that the item
being exchanged is embodied in human being.
 The ownership and possession of a commodity such as wheat is completely
transferable between buyer and seller. Whereas in labor market, the same
condition are not true, labor as a services is inseparable from the
person providing it and, thus, the work supplying labor and the firm
buying it must have a direct, personal relationship with each other.

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 Cont. ...
 So that, human beings have definite preferences with respect to
the conditions they work under. Implies that,
 Exchange in the labor market to be determined not only by the price
of labor but also by a host of non-economic factors that are largely
absent in commodity markets. These noneconomic factors are partly
physical in nature, such as the risk of injury on the job or the
pleasantness of the work environment, and partly social in
nature, such as the prestige of the job, the race or gender of
workmates, and the attitude of the management.
 Beside remunerations, there are also non-monetary/ non-economic aspects of
the job become extremely significant in the exchange in labor market. These non-
monetary factors include:
 Jobs health and safety features
 Arduousness (difficulty) of the work
 Stability of employment
 Opportunity for training and advancement
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 Cont…..
2. On the demand side: indirect/derived demand of labor service
 While the demand for a product is based on the satisfaction or utility
it yields, labor is demanded because of its contribution to
productivity in creating goods and service
 => demand for labor is derived from the demand for the products
it produces.
3. Heterogeneity of workers and jobs
 A third feature of labor market that distinguishes it from most
product markets is the extreme diversity in the characteristics
of the good being traded. Individual workers differ by age, race,
gender, education, experience, skills, and complex personality
factors, such as motivation and congeniality.

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