Chapter Summary

Key Concepts

1. The labor market is arguably the most important market in an economy. The tools of supply and demand allow us to understand the basic changes in the labor market that have occurred in the United States since 1950, including the increase in the employment-population ratio and the rising return to education.

2. Labor markets are typically characterized by large quantities of job creation and job destruction that result in much smaller overall changes in employment. Most unemployed workers find new jobs relatively quickly in the United States, and most unemployment is accounted for by people out of work for long spells.

3. Adverse shocks (like the oil shocks and productivity slowdown of the 1970s), as well as inefficient labor market institutions, appear to play important roles in explaining the relatively high unemployment rates and low hours worked in Europe.

4. Because the labor market is so important, problems like unemployment merit serious responses by society. Designing the right safety net requires balancing the needs for social insurance against the disincentives associated with the insurance.

5. Present discounted values help us compare financial payments received at different times.

6. The rising return to a college education is one of the key facts about the labor market. This college wage premium has risen from about 50 percent in 1963 to about 90 percent by 2002. Another way of viewing this fact is that wage inequality between college graduates and high school graduates has increased, mirroring a broader increase in income inequality. Possible explanations include skill-biased technical change and globalization.

1. Introduction

  • The wages of a person starting to work this year and continuing to work for the next 45 years are worth approximately $1 million in today's dollars.

2. The U.S. Labor Market

  • Wages account for two-thirds of per capita GDP.
  • Average wages have grown at 2 percent per year for the last century.
  • The employment-population ratio is the fraction of the civilian population over the age of 16 that is working.
    • The ratio has been increasing over time—in large part due to the entry of women into the workforce.
    • The ratio decreases in times of a recession.
  • The unemployment rate is the fraction of the labor force that is unemployed.
    • A person is unemployed if she does not have a job that pays a wage or salary, if she actively looked for a job during the four weeks before measuring the unemployment rate, and she is available to work.

a. The Dynamics of the Labor Market

  • Job creation and job destruction are the gross flows of jobs that are being created and destroyed every month as part of normal changes in the U.S. economy.
  • In normal times, most spells of unemployment are relatively short.
  • People who are unemployed for long periods account for most of the total weeks of lost work.
  • Many countries have developed social safety nets.

3. Supply and Demand

  • The labor demand curve is derived from the firm's profit maximization problem.
    • Firms hire workers until the MPL equals the wage rate.
    • The demand curve slopes downward because of the diminishing marginal product of labor.
      • As we add more workers and hold all else equal, each additional worker produces less.
  • The labor supply curve slopes upward because the price of leisure is higher when wages are higher.
  • The intersection of labor supply and demand determines the level of employment and the wage rate.

a. A Change in Labor Supply

  • If the government collects a tax on a worker's wage, the labor supply curve shifts left.
    • For any given wage, a worker receives less money and supplies less labor.
    • In order to be in equilibrium, firms must raise wages.
  • As firms raise wages, they will need to fire some workers and the unemployment rate will rise.
    • However, over time, workers will become discouraged and may drop out of the labor force.
    • If all workers become discouraged, the unemployment rate is unchanged in the long run.

b. A Change in Labor Demand

  • Suppose the government creates regulations making it harder to fire workers.
  • Thus, firms will demand fewer workers in the first place, because they will not be able to fire them later.
    • Labor demand shifts left causing wages and employment fall.
  • The unemployment rate rises initially and recovers as discouraged workers drop out of the labor force.

c. Wage Rigidity

  • Wage rigidity is when wages fail to adjust after a shock to labor demand or supply.
  • If wages are rigid in the example of labor demand given above, the failure of wages to fall to clear the labor market will result in a larger fall in employment.

d. Case Study: Supply and Demand Shocks in the U.S. Labor Market

  • Increases in the employment-population ratio are due in large part to increases in the number of women working.
    • Supply shocks include changes in social norms and changes in technology for managing fertility.
    • Demand shocks include reduced discrimination against women.
  • Rising unemployment in the 1960s and 1970s and the subsequent decline in the 1980s is possibly explained by the baby boom.
    • Young people have higher unemployment rates traditionally—and the baby boom increased the proportion of young people in those decades.

e. Different Kinds of Unemployment

  • The natural rate of unemployment is the rate that would prevail if the economy were in neither a boom nor a bust.
  • Cyclical unemployment is the difference between the actual rate and the natural rate and is associated with short-run fluctuations in output.
  • The natural rate of unemployment includes two components:
    • Frictional unemployment is due to workers being between jobs in the dynamic economy.
    • Structural unemployment results from the labor market failing to match up workers and firms in the market.
  • Actual unemployment equals frictional plus structural plus cyclical unemployment.

4. The Bathtub Model of Unemployment

  • The "bathtub" model is consists of two equations.
    • The number of people in the labor force must equal the sum of the number of employed people plus the number of unemployed people.
    • The second equation determines how unemployment changes over time.
      • The job separation rate is the fraction of people who start out with jobs but who lose their jobs each month.
      • The job finding rate is the fraction of unemployed people who find a new job each month.
  • When the change in unemployment is zero, the model is in steady state and the number of people losing jobs exactly equals the number of people finding jobs.
    • Because the equilibrium of the model is in steady state, we think of the model as determining the natural rate of unemployment.
  • An implication of the model is that the only way to alter the natural rate of unemployment is to change the job finding rate or the job separation rate.

5. Labor Markets around the World

  • Unemployment in Europe has been substantially above America's rate since 1980, while Japan's rate was until recently below the United States.
  • European unemployment has increased dramatically because:
    • Adverse shocks (the productivity slowdown and high oil prices) hit Europe and other countries.
    • Inefficient labor market institutions exist in Europe, because unemployment and welfare benefits are substantially higher.
      • Many programs are designed so that there is a high implicit tax rate for returning to work.

a. Hours of Work

  • By the 1990s, the number of hours worked in Europe had declined substantially from 1970s levels.
  • GDP per capita is lower in Europe because workers work less hours.
    • If the choice is voluntary, then Europeans enjoy leisure more and welfare is likely improved.
    • If the decrease in hours worked is a result of distortions in the labor market, it is likely not welfare enhancing.

b. Case Study: Efficiency Wages and Henry Ford's Five-Dollar-a-Day Plan

  • Ford instituted a five-dollar-a-day minimum wage.
  • The theory of efficiency wages recognizes that paying a wage greater than the wage needed to retain a worker may actually increase a firm's profits.
    • Paying higher wages allows workers to eat healthier and become more productive.
    • Paying higher wages ensures a higher level of effort and less shirking.
    • Higher wages will attract more able workers to a firm.

6. How Much Is Your Human Capital Worth?

  • The present discounted value of your lifetime income is likely greater than 1 million dollars.

a. Present Discounted Value

  • The present discounted value of an amount is the value of money you would need to put in the bank today to equal a given future value.
    • In other words, it tells how much a future payment or a future flow of payments is worth today.
  • The present discounted value is equal to the future value divided by the bracketed quantity [1 plus the interest rate] raised to the number of periods in the future.
  • To calculate the value of a stream of equal payments over a given number of years, arrange the sum of each period's present discounted values into a geometric series.
    • Then use the formula for a sum of a geometric series to calculate the present discounted value of the stream of payments.

b. Your Human Capital

  • The average income is $63,000, and if we assume no wage growth, an interest rate of 3 percent, and a lifetime work span of 45 years, the present discounted value of this stream of payments is 1.59 million dollars.

7. The Rising Return to Education

  • The premium to having a college degree relative to a high school degree has been rising rapidly over the last forty years.
  • The wage premium of a college degree over a person's years worked far outweighs the forgone wages and tuition costs of going to college.
  • As wages have grown, so has the supply of college graduates—such a supply shock implies wages should decline.
  • Because the supply of works has increased, it must also be the case that the demand for college-educated workers has increased by an amount large enough to offset supply.
    • Furthermore, the demand shift for college-educated workers must be large enough to also counteract any shifts occurring in the market for high school graduates.
  • Explanations for a large shift in demand for highly educated workers include the following:
    • Skill-biased technical change is the idea that new technologies are more effective at improving productivity of college-educated workers than of high school educated workers.
    • Globalization is the increased opening of trade. Because highly educated workers are a scarce resource in the world as a whole, trade will raise wages of college-educated workers.

a. Case Study: Income Inequality

  • According to Piketty and Saez's measure of income inequality based on tax return data in the United States, income inequality was high in the 1910s and 1920s, but it declined substantially during the Depression and World War II.
  • Starting in the 1980s, income inequality has risen sharply in the United States.

8. Chapter Review

  1. Summary
  2. Key Concepts
  3. Review Questions
  4. Exercises
  5. Worked Exercises