## Chapter Study Outline

1.1 Methodology

• Positive economics is concerned with description and explanation.
• Positive economics is the more scientific branch of the discipline and seeks to answer the question, “What is?”
• Normative economics is concerned with value judgments and applying positive economics to solve problems.
• Normative economics is the more subjective branch and seeks to answer the question, “What ought to be?”
• An analytical model is a way simplifying a situation in terms of mathematical equations, thereby permitting description and analysis. An analytical model must possess:
• Coherence: all of the elements of the model must fit together without contradiction.
• Simplification: the model must simplify the complexity of the actual situation in order to be useful.
• Axioms (assumptions): in a model, these form the rules and simplifications that allow the economist to focus on a particular set of variables.
• A common mistake is a failure to stay within the assumptions of the model by either ignoring the model’s axioms or fabricating new assumptions.
• Exogenous (independent) variables: the model treats these variables as given. Their determination lies outside the scope of the analysis.
• Endogenous (dependent) variables: the model seeks to explain only these variables. Their values are derived from the exogenous variables within the model.

1.2 The Supply and Demand Framework

• The function LS=S(W, N, WA) is a shorthand way of saying that the supply of labor hours, LS, depends upon the wage, W, the size of the labor force, N, and the wage available in alternative industries, WA.
• Ceteris paribus, which literally means “all else equal,” is the term for holding all other variables constant in order to observe the effects of a change in one variable.
• The labor supply curve, (S0), graphing LS as the dependent variable and W as the independent variable, is positively sloped because, all else equal, an increase in the wage of steelworkers, W, for example, will increase the number of hours worked in the steel industry, LS.
• LS and W are endogenous, and N and WA are exogenous.
• A movement along this labor supply curve is caused by a change in the wage of steelworkers, W.
• A shift in this labor supply curve is caused by a change in the wage available to workers in alternative industries, WA.
• The function Ld = D(W, Q, R) is a shorthand way of saying that the total demand for labor hours, Ld, depends on the wage, W, the demand for steel, Q, and the price of capital, R.
• Ld and W are endogenous, and Q and R are exogenous.
• A change in W leads to a movement along the curve; a change in R leads to a shift in the curve.
• The substitution effect dominates the relationship between the cost of capital, R, and the demand for labor, Ld, if an increase in the cost of capital decreases the demand for capital and increases the demand for labor, in which case labor and capital are gross substitutes.
• The scale effect dominates the relationship between R and Ld if an increase in the cost of capital decreases the demand for both labor and capital, in which case labor and capital are gross complements.
• The labor market is said to be in equilibrium when the equilibrium wage rate, W*, balances the supply of labor, LS, with the demand for labor, Ld, and there is no tendency for further change.
• If the wage rate is too high, there will be an excess supply of labor; if the wage rate is too low, there will be excess demand for labor.
• Though this model can deliver qualitative and quantitative conclusions about the labor market, it is limited by several omitted factors, such as the way that unions or regulations may violate some of the model’s assumptions.

1.3 Applications: Supply and Demand Shocks

• The simple supply and demand model can help explain the impact of real-world events on the labor market.
• A pandemic like the black death in 1347 may dramatically decrease the labor supply while only modestly decreasing the demand for labor, thereby raising the average wage.
• In 1987 the Palestinian intifada decreased the labor supply in Israel, thereby increasing the wage in Israel relative to Palestine.
• The burst of the dot-com bubble in 2002 resulted in a sharp decrease in the demand for labor in some regions, which led to a large reduction in wages.
• The Alyeska pipeline represented a positive labor demand shock causing a large and temporary increase in local wages.
• While the model can be very useful for explaining complicated events like these, it can be difficult to modify the model in order to incorporate other interesting factors.

1.4 Elements of Microeconomics

• Microeconomic theory forms the foundation of modern labor economics.
• Neoclassical economics comprises nearly all of mainstream modern economic theory. This approach has four central characteristics:
• Methodological individualism: the tenet of neoclassical economics that assumes that analysis of individual behavior can explain the behavior of a group
• Rational choice: all agents, including individuals and firms, will behave rationally so as to maximize a constant objective within a given set of variable constraints.
• The rational choice model will answer
• (a) Who is the decision maker?
• (b) What are the decision maker’s goals and objectives?
• (c) What constraints limit the decision maker’s choices?
• Marginal condition: analyzes the effects of a unit of change in one variable upon another variable
• Comparative statics: allows comparison of marginal changes by observing two equilibrium states
• Equilibrium: an economy is in equilibrium after the choices of the agents have resulted in a coherent allocation of resources based on the objectives and constraints of the agents.
• Partial-equilibrium analysis isolates the behavior of one group from the rest of the economy, while general-equilibrium analysis attempts to consider the interconnections of all groups of agents.
• Pareto efficiency: an allocation is Pareto efficient if, given the resources available, there are no other allocations that could increase the well-being of any member of the group without decreasing the well-being of another member.
• Pareto efficiency provides a weak, though widely accepted, normative criterion.
• Though Pareto efficiency is attainable under the principles of neoclassical economics, the principle of unintended consequences may cause an undesirable outcome despite individual optimizing behavior.
• New Institutional Economics (NIE) explains institutions in terms of the actions and goals of the individuals who participate in them, with a focus on the inner workings of the family and the firm. In contrast, neoclassical economics considers institutions as integrated decision makers.
• Bounded (or limited) rationality is the NIE modification of neoclassical rationality. The bounded rationality approach accepts that individuals want to optimize a goal, but they have limited ability to predict the outcomes of their choices.