Labor Market: Supply and Demand

00:01 Hello and welcome back to your online presentation of macroeconomics.

00:05 My name is James DeNicco.

00:07 This presentation will be about the labor market, both supply and demand.

00:11 We're going to start with some micro labor and build up into our macro models.

00:16 But I'm a firm believer that all good macro is based on good micro foundations, so I think it's worth taking some time to start at that micro model and build up.

00:27 So what exactly are you going to be doing in this presentation? We're going to be looking at the relationship between labor and production.

00:34 We're going to be looking at how many workers firms need to hire.

00:38 We're going to look at the relationship between wages and supply and wages and demand. We're going to find our market equilibrium where our supply equals our demand. And we're going to look at what shifts our supply curves and our demand curves. So first, we need to make some assumptions about our model.

00:56 We're going to assume that our capital is fixed here so that our only moving part is our labor, so we can concentrate on those production increases from adding another worker.

01:06 If we allow capital to move around, that complicates the issue.

01:10 We just want to focus on labor here.

01:12 We're going to assume that our workers are homogeneous so everybody gets paid the same wage. If one worker is more skilled than another worker, they're going to demand a higher wage. We're going to assume that away, for simplicity's sake.

01:24 You can complicate these models if you want, but to be honest, the basic intuition doesn't change all that much.

01:30 You can get more intuition out of a model if you complicated, but for the purposes of this course, the basic model will suit.

01:38 We're going to assume that firms maximize profits.

01:41 Most of the time, people don't have a hard time believing that.

01:44 So firms aren't going to hire you to give you a wage.

01:47 They're going to hire you to maximize their profits.

01:49 They're only going to hire you if you don't cost them more than you benefit them.

01:54 So if you cost them more than you benefit them, they're going to say, no, thank you.

01:58 We're also going to assume that we have competitive markets so that nobody has power over prices.

02:05 Those are our assumptions going into it.

02:07 Now, let's get to the demand side a little bit here.

02:10 Let's take an example.

02:11 Let's assume that I own a hoagie shop.

02:14 We have a special.

02:15 We're selling Capicola Hoagies.

02:18 You don't know what Capicola is.

02:19 It's a nice, spicy, sweet ham.

02:21 It's delicious. A Capicola hoagie with some oil and vinegar, a little salt.

02:25 Pepper. Oregano is beautiful.

02:27 It's fantastic.

02:28 So we're selling these for $10.

02:31 We're paying our workers $80 a day.

02:34 We have our schedule of production.

02:36 We have a number of workers and the number of hoagies we can produce with that number of workers.

02:42 So with one worker, we can produce 11 hoagies, two workers, we can produce 20 hoagies, three workers, we can produce 27 hoagies.

02:51 And all the way down to the line, if we have six workers, we can produce 36 hoagies.

02:57 So what characteristic do we see being displayed here in our increase in production? Well, it's going to be the diminishing returns.

03:07 Again, we're going to have diminishing marginal productivity of labor.

03:11 In other words, we're going to have an increase in production as we add workers.

03:16 But that increase is going to get smaller and smaller and smaller.

03:21 So if you look, what's our marginal product of labor? So our first our first person we hire adds 11 hoagies in production. The second worker we hire, we're up to 20 hoagies, but 20 -11. The second worker only adds nine Hoagies the third worker, we're up to 27 hoagies.

03:41 But the marginal production, the incremental increase is only 7 Hoagies -20.

03:47 And you do that all the way down the line, 36 -35 hoagies. That six person only adds one hoagie.

03:56 So what does this look like? Graphically, it looks like this.

03:59 The curve starts to flatten out again as we add more workers and we become more productive.

04:05 But the increases in production diminish.

04:08 They get smaller.

04:09 What's the intuition behind that? Well, think of a coffee shop with one coffee machine.

04:15 So you have one coffee machine, you have zero workers.

04:18 Obviously, you can make no coffee.

04:20 You add that one worker and production jumps off the page.

04:24 It increases at a rapid rate.

04:26 We have a huge increase in production with that first worker.

04:29 Now we're able to produce coffee.

04:32 We hire a second worker? Yes. We're going to have an increase in production.

04:36 While that first worker isn't at the coffee machine, he's going out and he's handing coffee around to people.

04:42 He's serving the coffee.

04:43 Now, a second person could come in and be making coffee, so there's less idle time for the capital sitting there.

04:50 Remember, we assumed fixed capital.

04:52 So we're going to stay with one coffee machine.

04:54 So the second person we hire, there's less downtime while the first person is out serving the coffee you make.

05:00 Now somebody is using that machine, so productivity is gone up.

05:03 However, sometimes the first worker is going to be at that coffee machine, the second worker he's going to be after, he's going to have to be waiting.

05:12 He's going to be standing in line.

05:13 He's going to have some idle time, some downtime.

05:16 So that means the increases in production are smaller.

05:19 The third worker, again, less downtime for that one machine.

05:23 There's probably always somebody at that machine now.

05:26 So production is going up.

05:28 But with three workers, you're going to have a lot more instances of somebody standing there waiting to use that machine.

05:34 So increases in production gets smaller and smaller and smaller.

05:39 You can think of it the same with the hoagies.

05:41 There's one hoagie station.

05:43 Hoagie Station is your Capital One worker.

05:46 He's always busy.

05:47 The increase in production is huge at a second and the third worker more often somebody is going to be standing in line waiting to use that hoagie station.

05:56 So production increases diminish.

06:00 That's going to drive a lot of our results.

06:02 Now let's fill out the rest of our table now that we have a marginal product of labor.

06:06 Let's look at the cost side.

06:08 What is our marginal cost of each worker? Well, first, the cost.

06:13 How much does it cost to hire workers? One worker cost $80 wages or $80.

06:18 Our second worker.

06:19 Now we're up to a total of $160.

06:22 We add another $80 all the way down the line.

06:26 We have six workers.

06:28 We pay each of them $80.

06:29 Six times 80 is $480.

06:32 But what's our marginal cost here? So if our marginal benefit is the incremental benefit from adding one more worker, the marginal cost is the incremental cost from hiring one more worker. Well, here we assume our only cost is our wages.

06:48 So the marginal cost of adding another worker is just the wage.

06:52 It's $80, so it stays constant throughout.

06:56 Now this is our marginal cost in nominal terms, in dollar figures.

07:00 Let's get it into real terms or quantity.

07:02 We do that by dividing by the price of the hoagie.

07:06 So if each wage is $80, we're paying each guy $80.

07:11 Well, then the real marginal cost in terms of hoagies is $80 divided by the price of the hoagie, or $10.

07:18 So the marginal cost of each worker is eight hoagies.

07:22 Each person we hire costs us eight hoagies.

07:26 Now we have all the information we need to decide how many workers we want to hire. We take a look.

07:32 The first worker adds 11 hoagies.

07:35 He costs us eight hoagies.

07:36 We want that worker.

07:38 The second worker costs the adds nine.

07:41 Notice he costs us a hoagies.

07:43 We want that worker.

07:45 The third worker.

07:46 He adds seven hoagies.

07:48 He costs us eight hoagies.

07:51 We don't want that guy.

07:52 Right? We tell him to go home.

07:53 You're unneeded. You cost us more than more than you're making us, pal.

07:57 So we don't want you.

07:58 We're here to maximize our profits.

08:01 We're not here so that you can earn a wage.

08:03 So we're going to stop here at two workers.

08:07 The rule of thumb is the marginal benefit has to be greater than or equal to the marginal cost.

08:14 It it's okay if they're equal to each other.

08:16 If the guy brings in a hoagies and cost eight hoagies, that's fine.

08:20 That's our indifference point.

08:21 We decide to draw the line.

08:23 At that point, we're not terribly mean, we're just a little bit mean.

08:26 So if the guy doesn't cost us anything, we'll hire him.

08:30 But if the worker costs more than you benefits us, we don't want that worker so we can look at it graphically here.

08:37 So we see our marginal product of labor.

08:39 It's going down. It's always positive.

08:42 It's always in the upper right hand quadrant.

08:44 So it's always positive, but it's diminishing.

08:47 It's going down.

08:49 Our marginal cost is constant.

08:52 It's the straight line across here.

08:54 So it's eight hoagies per worker.

08:57 The triangle before they intersect, that represents that represents the available profit. That's the profit we can exploit inside that triangle.

09:07 So we want to exploit that whole triangle.

09:09 We want to get all the profit we can.

09:11 So we're going to increase our workers up to the point where these two lines intersect. Now for a marginal product of labor goes up, we get more production per worker.

09:22 We're going to want to hire more workers.

09:25 If our marginal cost goes down, then we're going to want to hire more workers because we can go further until our marginal benefit equals our marginal cost. So we want to take advantage of that whole triangle where the profit that we can acquire.

09:42 Now we can take the micro and we can aggregate it up into the macro.

09:47 We'll just assume that all firms are the same so that if it were eight workers before or two workers before now we have 100 firms that looked that like that. 100 times two is 20.

09:59 We're going to aggregate that micro up into our macro model.

10:02 And here we're taking a look at our demand for labor in our graph, for our demand for labor on a vertical axis, we have a real wages.

10:12 That's also our marginal cost of labor.

10:15 On the horizontal axis, we have our number of workers.

10:19 So you'll see that our demand for labor is downward sloping.

10:23 What that says is as the real wage goes down, we want to hire more workers.

10:29 So if we go back one graph, we're saying the marginal cost is going to shift down. If that marginal cost comes down, we want to hire more workers because the marginal benefit will outpace the marginal cost for a longer period of time.

10:46 So we see that downward sloping demand curve.

10:50 Now let's shift from the demand side to the supply side.

10:53 So on the supply side.

10:56 We're going to take a look at our incentives to work.

10:59 So labor supply, that's the workers, how much labor they're willing to give.

11:04 So in economics, labor detracts from our leisure.

11:08 We like to enjoy our leisure.

11:10 We don't like to work.

11:12 There's two goods in economics.

11:14 Leisure is a good thing and consumption is a good thing.

11:17 Work is a bad thing.

11:19 We would rather be able to consume as much as we want while we enjoy as much leisure leisure as we like.

11:24 But it's impossible.

11:25 In order to get some consumption, we have to work because we have to earn wages.

11:30 So we're willing to give up some of our leisure in order to earn wages.

11:35 So that we can consume.

11:37 We need to consume to survive.

11:38 We need food, we need clothes, we need shelter.

11:41 But we also consume because it makes our leisure better.

11:45 It's nice to go to the beach, but wouldn't you rather go to the beach if you could afford to buy a yacht and go around the water, take all your friends out and have a fun time. So we consume for survival, but we also consume for utility to make ourselves happy.

11:59 So we're willing to give up some of that leisure time so that we can work and earn wages and consume.

12:06 So as wages change, there's going to be two effects that we see.

12:11 The first is going to be the substitution effect.

12:14 So the substitution effect is going to tell us that as wages go up, we're more willing to substitute away from leisure towards labor.

12:23 The reason being is the opportunity cost of leisure has risen.

12:28 Opportunity costs.

12:29 Those are the cost you give up to get something.

12:32 They can be direct or they can be indirect.

12:36 So if you go to the movies, the direct cost of that, the direct opportunity cost, it's the money you pay for the ticket, the money you pay for your popcorn.

12:44 You can. The indirect cost of that are the wages you're missing out on that you could be earning if you were at work, but you decided to go to this movie.

12:54 So the opportunity cost of leisure, which going to a movie might be part of that, are wages you're missing out.

13:00 So as those wages go up, the opportunity cost of leisure increases. So as the cost of leisure increases, you're more willing to substitute away from that leisure towards labor to earn those higher wages.

13:15 There's also what we call the income effect.

13:17 The income effect says as wages go up, we demand more leisure.

13:23 That's because leisure is what we call a normal good for normal goods.

13:28 If we have more income, we want more of those normal goods, sports cars, nice clothes, as opposed to inferior goods.

13:35 Most people talk about ramen noodles.

13:38 That's a type of soup a lot of college students eat because it's very cheap, but if they had more money, they might buy themselves some Campbell's Chunky Soup or something. That's a little better.

13:47 Leisure is like Chunky Campbell's Soup.

13:50 It's a it's a normal good.

13:52 So if we have more income, we want more of it.

13:55 So as our income rises, we want more leisure time.

13:59 So most of the people that have this effect dominating would be like your high powered lawyers. They're making enough per hour that now they can work less hours and be satisfied.

14:10 When you enter a law firm, you don't make a lot of money.

14:12 So you might only take a week's vacation a year.

14:15 But as time goes on, maybe now you're the senior partner.

14:18 You're making millions of dollars a year so you can work less and take more vacation time. Now, maybe you take three or four weeks of vacation a year or you're an actor, you start out, you're getting paid very little for each move you make.

14:31 So you work all the time.

14:34 But now that you're a big time, big name actor and everybody loves you, you get paid $20 million a film.

14:39 Now, maybe you only make three films per year because you make enough making those three films that you would rather have more leisure time.

14:48 So the substitution effect says that as wages go up, you supply more labor.

14:52 The income effect says is wages go up, you supply less labor.

14:58 Most people live in the range where the substitution effect dominates.

15:02 Most of us aren't high paid actors.

15:04 Most of us have were paid more.

15:06 We're going to work more.

15:07 So the substitution effect, the macro sense is going to dominate so that we draw our upward sloping supply curve.

15:16 So is the real wage goes up, we're going to substitute a way from leisure towards more labor.

15:22 We are going to increase our supply of labor so we have a downward sloping demand curve and our upward sloping supply curve where they come together makes our market equilibrium.

15:33 So we have our market equilibrium level of of labor and we have our market equilibrium clearing real wage.

15:41 So that's where supply equals demand.

15:44 And this model here, there would be no unemployment.

15:46 Everybody that wants to work has found work.

15:50 So labor supply equals labor demand at this point.

15:54 So what shifts these demand curves around? Well, let's take a look at it here.

15:59 All right. Movements along the curve.

16:02 They're going to come from changes in the real wage.

16:05 As the real wage goes down, labor demand increases.

16:09 As wages go up, labor demand decreases as wages go down.

16:13 Labor supply is going to decrease as wages go up.

16:17 Labor supply is going to increase.

16:19 That's what we talked about.

16:21 But it can be something other than wages that shifts labour demand and labour supply. In fact, anything that changes the supply or demand of labor other than wages is going to be a shift in that graph.

16:33 So first, let's take a look at anything that might increase the marginal product of labor.

16:39 If the marginal product of labor increases, as we know, going back to our graphs of the Capicola, special example I did as the marginal product of labor goes up, each worker brings in more productivity.

16:53 So you're going to want to hire more workers.

16:56 That will shift our demand for labor to the right.

16:59 As we demand more labor, that raises the price of labor.

17:04 So we'll see a higher equilibrium, real wage, and then higher equilibrium level of labor, level of employment.

17:12 Still no unemployment in this model.

17:15 Supply equals demand.

17:17 So what about our labor supply? Well, let's take a look at a decrease in the working age population.

17:23 Say, like in the United States, we have our baby boomers.

17:26 We have a large number of people that are getting to the point where they're going to retire. So they're going to get out of the labor force.

17:33 They're not going to participate anymore.

17:35 So that would decrease the amount of workers, that would decrease the supply of labor. As the supply of labor decreases, it will shift to the left.

17:45 Here, in these graphs, the right is always an increase.

17:48 The left is always a decrease.

17:49 You look at increases along the horizontal axis.

17:52 To the right is an increase in labor, to the left is a decrease in labor.

17:57 So we're going to have a leftward shift in the supply curve as there's less supply of workers, firms are competing for less workers.

18:04 That raises the real wage.

18:07 So the market clearing equilibrium, real wage goes up and the equilibrium level of employment decreases to the left.

18:15 So we've looked at some of the things that are going to shift supply and demand.

18:18 Anything that changes the marginal product of labor up will shift demand curve to the right. Anything that decreases the marginal product of labor will shift the demand curve to the left. Anything that increases the number of workers out there is going to increase the labor supply to the right.

18:34 Anything that might decrease the labor supply will shift the labor supply to the left. Up to this point, we've had no unemployment.

18:43 Now, there's a lot of theories out there that exist about why there is unemployment.

18:47 Some of the big ones, the searching, matching search and matching model for Mortenson and besides they just won the Nobel Prize were firms and workers just have a hard time finding each other.

18:58 It just takes time.

18:59 There's the efficiency wage model where you pay workers above the going wage or above the market clearing wage so that they work harder for you so that they have an incentive to work harder for you.

19:10 And there's also theories of minimum wage.

19:13 So the minimum wage debate is a fun one to talk about.

19:16 We'll focus on that here.

19:18 And so it's quite controversial.

19:20 So here's the classic example of what happens when you institute a minimum wage above the market clearing.

19:27 So we have a market clearing level of wages, a real market clearing equilibrium, real wage, where supply and demand intersect.

19:37 Now we institute a minimum wage above that market clearing.

19:40 What does that do? Now, all of a sudden, we've gone from no unemployment in our graph here to having some employment. Now our labor supply outpaces our labor demand. We have a labor supply greater than labor demand.

19:56 Not everybody that's looking for work can find work.

19:59 We have a labor surplus from the price floor that we instituted.

20:04 We instituted a price floor.

20:06 The price here is the price of labor.

20:08 So when the price floor is above the market clearing equilibrium wage, it's going to be what we call binding.

20:16 If it were below the market clearing equilibrium real wage, it would have no effect. But because the lowest the wage can go is above the market clearing, we're going to have a surplus of workers.

20:27 Supply is greater than demand.

20:30 We're going to have some unemployment.

20:32 So you're picking winners and losers whenever you instituted a minimum wage. The people that win are the ones that maintain their jobs. And get a higher wage.

20:45 The ones that lose are going to be the ones that had jobs before at the market clearing wage, but now at the minimum wage, they've lost their job.

20:54 So there's a lot of debates out there.

20:57 And what they stem around is whether there's more winners and losers.

21:01 A lot of it is going to depend on the elasticity of this demand, which talks about how responsive demand is to a change in the price.

21:09 So if this demand curve were much steeper, that would mean the demand is less responsive to a change in the wages or a change in the price.

21:19 The steeper the demand curve is, the more winners you're going to have, the less losers you're going to have.

21:25 The flatter that demand curve is, the more responsive demand is to changes in price. So as the minimum wage goes up, there's going to be more losers and less winners.

21:37 That's what a lot of the debate stems around.

21:39 There's other things involved.

21:41 There's wage compression.

21:42 People worry that if you increase the minimum wage, you might help entry level workers, but the workers above the middle management, that might decrease their future increases in wages.

21:53 So that might hurt their chances of upward mobility and increasing their standards of living. And there's also concerns about inflation.

22:01 But this is the basic model from the minimum wage debate.

22:05 So really the argument stemmed around are there more winners, are there more losers? Obviously, in the micro sense, there's going to be some of both.

22:12 In the macro sense, which one bears out, which one dominates.

22:16 So that's your basic minimum wage debate right there.

22:21 So what have we covered here in our labor supply and demand presentation? We learn the increases in labor increase production at a decreasing rate. We have these diminishing returns to productivity.

22:34 So the marginal product of labor is diminishing.

22:38 We know how firms make their hiring decisions.

22:41 If you make me more than you cost me, you're fine.

22:43 I want you. You cost me more than you make me.

22:45 Sorry. I'm not here for you.

22:47 I'm here to maximize my profits.

22:49 That's one of our assumptions.

22:51 We learned about labor supply and demand.

22:53 What moves us along the curves and what shifts the curves.

22:57 And now we also have a little bit of understanding of the minimum wage debate.

23:01 So that's your labor supply presentation.

23:03 Thank you.